I N R E V I E W

36 / Regulation / Spring 2015
IN REVIEW
A Liberal Heretic
Contradicts Piketty
✒ Review by Ike Brannon
I
s Peoria, Ill., special? Of course it is, says I—along with the thousands of other people who, like me, hail from the central Illinois
community. It’s a great city with wonderful people, as well as a rich
culture and heritage that belies the common perception of it being
provincial bore or a totem of flyover country.
I’m being facetious in positing such
a banality, of course. As a public policy
writer with precisely one shtick—being
from Peoria—I’ve laid a foundation for its
specialness in myriad ways, mentioning
it in over a dozen articles in 2014 alone.
Subtle I’m not.
What I’ve been wondering the last few
months is whether Peoria is somehow economically special. I’ve been trying to reconcile my knowledge of the town and the
people who live there with the research
of Thomas Piketty, Emmanuel Saez, and
various other top-drawer academics purporting to show that the plight of the
middle class—the folks who people Peoria—has been getting worse over the last
three decades.
It’s now conventional wisdom that any
economic growth we’ve seen in the last 30
to 40 years has gone mainly to the wealthy.
Piketty’s recent book, Capital in the 21st
Century (see review, Fall 2014), attributes
over 90 percent of all income gains from
improvements in productivity to the top
10 percent of income-earners, leaving the
rest of us to fight over scraps. Esteemed
Brookings Institute scholar Isabell Sawhill
has written that the plight of the working class hasn’t improved since the 1960s.
When Greg Mankiw suggested that their
situation might not be as morose as it’s
Ike Br a nnon is a fellow at the George W. Bush Center
and president of Capital Policy Analytics, a consulting firm
in Washington, D.C.
being made out to be, he was heckled and
shouted down—at an academic conference.
It’s now become politically incorrect to
dare contradict the notion that life’s getting more precarious for people who aren’t
at the top of the income ladder.
The suggestion that living standards for
most households are worse today than in
the 1970s is absurd to anyone who remembers that era of unreliable Country Squire
station wagons, music on AM radio, a
broadcast universe of precisely three television stations that signed off at midnight,
and a narrow offering of movies, music,
restaurants, literature, and culture that
represent a minute fraction of what any
American with access to the Internet can
find today. There are childhood cancers
that few survived 40 years ago that are
now easily curable—an improvement for
both rich and poor households that’s not
quantified in most articles about living
standards.
But the other experience that makes me
question whether things are getting worse
for the middle class is that my friends
who have chosen to remain in Peoria—
largely blue-collar workers without college degrees—seem to have the world on
a string.
Steve Rose is the rare economist willing
to question the conventional wisdom. In
two recent monographs he methodically
lays out the postwar income and spending patterns, and by doing so systemati-
cally destroys the axiom that the greater
income dispersion since 1980 implies that
the lower and middle classes are worse off.
Rose is in a unique position to question
the accepted wisdom: He is the author
of Social Stratification in the United States, a
fact book and poster he has been updating since 1978. Few would dare question
either his liberal credentials or his empirical chops, which have of late led him to
places where other Democrats would
rather he didn’t go.
Small-town living / Last summer I took
leave of my wife and children and spent
a few weeks with my parents back home.
With a lot of free time and no familial
obligations, I managed to catch up with
a host of old friends and classmates who
never left town. What I found was that
most of them—many of whom are in their
40s, married, with kids at or approaching
college age—have a lifestyle I cannot afford
in my big-city neighborhood and with an
income several times higher than theirs.
One friend—who’s now my hero—has a
motorboat, a Harley, a country club membership, and two kids in college that he’s
paying for—all of which he’s doing on a
family income of $110,000. Over several
nights of beers at a cozy bar on the Illinois River in nearby Mossville, we bought
drinks for a number of former classmates,
neighbors, and friends while chatting
about their careers and financial situation.
The career path for blue-collar workers
in my hometown is almost formulaic: the
guys who went on to get some post–high
school training end up being welders or
pipefitters or in some other occupation
that pays somewhere around $75,000. A
few do better than that—more than one of
my friends spoke enviously of our friend
known about town as the “Picasso of the
backhoe,” who commands a premium and
is never without a job because of his speed
and deftness with his implement. People
assumed he cleared $100,000. There are a
Spring 2015
few who are commercial truckers and earn Dicing the data / That my central Illinois
a bit below $75,000 as well as a few guys friends are doing well and are not so difwho started businesses and are a good step ferent than other blue-collar workers in
above this, but the distribution is bunched. their cohort is comforting, but also a
What’s more, these guys almost all mystery. How does Rose get such a difhad spouses working and earning decent ferent result than Piketty? Rose begins
pay. A number of the spouses were nurses, by pointing out that the bottom quintile
making around $50,000 a year themselves, of “earners” that Piketty spends so much
and those without any college tended to time worrying about in his work reprebe receptionists and earned
sent, in fact, not households
about half of that. It adds Was JFK Wrong? Does at all but rather the children
Rising Productivity No
up to an average household Longer Lead to Subof other earners, living at
income for my blue-collar stantial Middle Class
home. There’s a big differfriends of roughly $100,000 Income Gains?
ence between the median
a year in a community where By Stephen Rose
income of Piketty’s bottom
nice homes cost $150,000 and 28 pp.; Information
20 percent of earners, at a
public schools are fine. That Technology and Inno- mere $2,000, and that of the
vation Foundation,
makes for a very nice life.
2014 Congressional Budget
December 2014
I assumed that my town or
Office report on U.S. income,
group of friends was anomawhich reckoned their income
lous. Not so, says Rose, who
in the five-figures, or an order
reports a median household The Economy Goes to of magnitude higher.
College: The Hidden
income for married families
The difference isn’t perPromise of Higher
of ages 48–59 to be nearly Education in the
plexing: the CBO—correctly,
$90,000, a number so out of Postindustrial Service in most people’s eyes—
line with the implied blue- Economy
excluded the millions of tax
collar poverty of Piketty and By Stephen Rose
filers who are school-age
Saez as to be unbelievable.
Georgetown University dependents or else are retirees
Part of what’s going on, of Center on Education
collecting Social Security. The
course, is that there remain and the Workforce,
former are not who we typiforthcoming.
significant life-cycle differcally think of as “the poor,”
ences in earnings, and there
and retirees—who depend on
is a very real fear that today’s
pensions, saving, and Social
struggling twentysomethings will never Security—are not nearly as poor as their
be able to get a solid hold onto the career reported income would lead us to believe.
track anywhere.
By excluding such households, the CBO’s
It’s a fear my friends shared when they universe consists of 118 million U.S.
were starting out. Few of them made much households versus Piketty’s 157 million.
money in their 20s. The 1980s were a tryThe other important difference in
ing time for Caterpillar, which is by far the the two data sets has to do with definarea’s largest employer, and the burgeon- ing income. Piketty chooses to use pre-tax
ing baby boomer generation entering the income and ignore all transfer payments,
job market conspired to create high unem- both of which have the effect of narrowing
ployment rates in Peoria throughout that the income distribution. The CBO, on the
decade. Few in my crowd who remained other hand, is more focused on actual livin Peoria got married before the age of 30 ing standards and thus includes those in
simply because they didn’t earn enough the mix. The result is, again, a vast differto support a family. But a decade of gain- ence between the incomes of the bottom
ing skills and building connections in the quintile and those at the top.
job market and an improving economy
Rose agrees with the CBO, arguing
eventually opened up opportunities that forcefully in his recent studies—Was JFK
my friends were able to exploit.
Wrong? and The Economy Goes to College—
/ Regulation / 37
that living standards need to be the focus
of the debate. The former study, which is
to some degree an updating of his forceful 2010 book Rebound, shows that, when
measured properly, living standards for
the poor and middle class have risen
steadily over the past 40 years and that
trend shows no signs of dissipating, even
after the financial crisis and accompanying recession. Rose’s data show that real
median household income went up 33
percent from 1979 to 2007.
Other research has called into account
the very notion of a growing gap between
the rich and poor. For instance, the difference in consumption patterns between the
top quintile and bottom quintile is much
narrower than the income data would suggest. Gene Steuerle, an economist at the
Urban Institute, has pointed out that even
the widening of the income gap depends
on how both income and dispersion are
measured, observing that the gap between
the person at the precise 20th percentile
and the precise 80th percentile (which is
different than the mean of the bottom
and top quintile, as is typically presented)
has not changed over the last few decades.
Every piece that dares question the
claim that life is growing more onerous
for everyone who’s not at the top of the
income pyramid conditions such heresy
with various caveats, averring that we still
need to do more about the scourge of
income inequality and the plight of the
poor and whatever else might suffice as
a bone to the attack dogs on the left. To
his everlasting credit, Rose—a man who
arguably has thought longer and harder
than anyone else about this issue—largely
dispenses with such banalities.
The difference between the rich and
poor is the wrong metric for discerning the
plight of the poor. If we look at their living
standards from a historical basis, it’s clear
that their life is much better today than 20
or 30 years ago. We live in a society where
many poor households have cell phones and
computers that are far better than any that
existed a decade ago and that can be had for
less than $100. To be clear, Rose isn’t a fan
of rising income inequality, but he argues
38 / Regulation / Spring 2015
in review
that the living standards of the poor, not
their relative income, needs to be the focus
of our public policy machinations.
In The Economy Goes to College, Rose
marshals up a wealth of evidence to support the claim that living standards are
improving. For this, he uses data from the
Commerce Department’s Input–Output
Accounts to measure the proportion of
consumer expenditures that go to various categories. The biggest change the
data reveal is that food and clothing—two
necessities that took almost half of all consumer spending in 1947—today require
just 18 percent. So what do people spend
money on today? Recreation (which went
from 8 percent of spending to 14 percent)
and health care (which quadrupled to 20
percent in 2007). And while the reflexive
response of many to this latter statistic is
to lament that “rising cost,” it’s helpful to
remember how much better health care
became over this period—we spend more
for health care, but we also get more from
that spending. In 1947 the typical doctor’s
advice to the survivor of a heart attack was
to get one’s affairs in order.
Too good to fact-check / Despite Rose’s ped-
igree and his meticulous, thoughtful studies
pointing out that the supposed stasis in living standards for the poor and middle class
doesn’t hold up, a contrary narrative has
taken root in the media and few dare to contradict it. Nobel-winning economist Joseph
Stiglitz, who followed Rose on a panel at an
academic conference devoted to inequality
in January, remarked that he had no idea
that people found flaws with Piketty’s data.
When someone widely regarded (by himself and others) as the smartest economist
in the profession can’t be bothered to read
anything contrary to what he declares to be
the most important issue of our time, it’s
clear that an intellectual battle is over, and
those who want to continue it can’t expect
to be treated politely.
Journalist Rod Dreher garnered much
attention with his 2013 book The Little Way
of Ruthie Lemming, a moving portrait about
his hometown’s embrace of his sister as she
fought cancer. The warmth he felt for the
town led him to reject the big-city rat race
and move back to the town later in life to
raise his family. It’s a story that those of
us who’ve abandoned our hometowns can
empathize with from time to time.
But my fleeting pangs of longing for
home aren’t because I’m trapped in some
big-city rat race. The notion that it’s harder
to make friends and be a part of one’s community or that we all work harder in a big
city is nonsense. Rather, I’m jealous of the
lifestyle my blue-collar friends back home
have achieved.
My friends who stayed married and
aren’t afraid of hard work have created good
lives for themselves in our blue-collar hometown. The march of progress hasn’t cost any
of them their jobs, either; rather, it’s made
living in a pleasant community even better
than it was a generation ago. Their televisions, pickup trucks, and telephones are
miles ahead of anything the richest of the
rich could have obtained just 20 years ago,
let alone in the halcyon days of our youth.
Peoria and Mossville are not unique,
Rose has shown. While blue-collar jobs
these days may require more training and
experience than they did a generation ago,
the notion that people who don’t finish
college are doomed to penury is greatly
overstated. If we’re going to begin the
debate over how to raise living standards
with an empirical story in which the data
used bear little resemblance to the real conditions and that cannot be questioned, the
prospects of reaching some sort of agreement are slim.
And that’s probably for the best. Piketty’s prescription of greater income redistribution isn’t going to do much for my
blue-collar friends back home, let alone
the rest of us.
More than a Principal
Deputy Assistant
✒ Review by Pierre Lemieux
R
obert Litan is an economist and lawyer who has moved between
think tanks (the Brookings Institution and Kauffman Foundation), the private sector (Bloomberg), and numerous government
jobs. This book, one of the two dozen he has authored or coauthored,
pursues two broad goals: showing that “economists and their ideas
have made important contributions to the
world of business” and to better public policies. They have created benefits worth trillions of dollars—hence the title of the book.
/ Economic ideas,
Litan claims, “have directly made money
for firms” (emphasis in original). For
instance, the idea of price discrimination (charging a lower price to the most
price-sensitive consumers) comes from
economists. The book gives many other
convincing examples.
Economics at work
Pier r e Lemieux is an economist affiliated with the
Department of Management Sciences at the Université du
Québec en Outaouais. His latest book is Who Needs Jobs?
(Palgrave Macmillan, 2014).
Consider the proliferation of auction
practices in today’s business activities. In
the 1960s, Julian Simon conceived the
idea of auctioning overbooked seats on
planes—specifically, using a reverse auction, which would pay the minimum price
necessary for passengers to happily switch
to another flight. Today, this idea is only
imperfectly applied, as airlines typically
offer vouchers to passengers who volunteer to be “bumped.” Another example is
Google’s auctioning of online ad space,
which company executives initiated without apparently realizing that they were
using a sort of auction previously designed
by Nobel prizewinning economist William
Spring 2015
Vickrey. Google later hired Hal Varian to requests and men, therefore, were getting
improve its auctions and data processing. too few replies to their approaches. The
Although Litan does not put it in these economists’ solution was to increase the
terms, economists naturally think in terms cost of men-to-women communications by
of auctions because they understand that limiting their number. Another dating site,
free-market prices are, in fact, the result of Whatsyourprice.com, openly put a money
continuous silent auctions.
price on communications and dates.
Another example of the usefulness
Economists have contributed much to
of economists is the recent explosion of the financial industry. They have shown
“data mining” or “Big Data,” which has that, for any given level of risk, a diversibeen made possible technologically by the fied portfolio brings higher returns. This
growth of computing power and the pro- discovery led to the 1970s creation of index
liferation of data available on the Internet. funds, mutual funds made of diversified
Statistical techniques are essential for pro- stocks or other financial instruments.
cessing these data (on prices,
Index funds have consistently
choices, consumers, other
generated higher returns than
businesses), but economists
actively managed funds. The
are useful to interpret the staEfficient Market Hypothesis,
tistical results—and to know
which claims that no stockwhat to look for in the first
picker can consistently outplace.
perform the market because
Perhaps the best example
all available information is
of Big Data is the increasing
incorporated in the prices
use of statistical analyses in
of financial instruments,
hiring players and devising
formalized this idea. Eugene
strategies in sports. Michael
Fama won the 2013 Nobel
Lewis’s book Moneyball, about
Prize in economics for his
Trillion Dollar Econothe statistical work used by mists: How Economists work in this area.
Billy Beane and the Oakland and Their Ideas Have
Although options (tradA’s front office, was turned Transformed Business able contracts to buy or sell
into a (good) movie with By Robert E. Litan
commodities or, now, other
Brad Pitt. Big Data is espe- 400 pp.; Wiley & Sons, financial instruments) have
cially prominent in adver- 2014
existed for centuries, three
tising and marketing: “Do
financial economists—Fisher
customers respond better to
Black, Myron Scholes, and
solicitations in blue or white envelopes?” Robert Merton—contributed to the growth
Similarly, Litan tells us that “there is no of this market by developing a famous
single Google website”; instead, visitors options pricing formula to determine what
are presented a number of different Google an option should be worth.
homepages so that their reactions can be
Public policy implications / Economists have
measured in order to optimize the site.
Another field where economists have also contributed much to public policy.
helped business is matchmaking between Litan emphasizes the importance of entresuppliers and demanders where prices do preneurship and blames economists for
not provide a sufficient signal. Examples “failing to recognize how increasing bureauof this include sectors where pricing is cracy and regulation are stifling American
forbidden, like in organ transplants, or entrepreneurship.” But economists have
the good is subject to information asym- also been instrumental in the deregulation
metries (the seller knows more than the experiments that began in the 1970s.
At the time, transportation was heavily
buyer), like in online dating. Cupid.com
hired two economists to solve a vexing regulated. Litan reminds us that “airlines
problem: women were receiving too many could not transport air cargo by truck
/ Regulation / 39
beyond 20 miles of an airport.” Like airlines, truckers were subject to rate fixing
and route controls. He notes, “Economists
from across the political spectrum were
well ahead of the politicians and regulators in advocating deregulation.” Without
deregulation, much of the online commerce revolution and just-in-time delivery
systems we know today could not have
happened. And airline fares would probably be double what they are now.
Starting with Jimmy Carter’s administration, oil prices were also deregulated
thanks to the advice of economists. This
was “yet another example,” writes Litan,
“where a Democratic president and a Democratic-controlled Congress did what free
market Republicans had long been associated with—letting the market, rather than
the government, set prices.” This deregulation paved the way for the ongoing shale
oil revolution.
What is surprising about all these regulations is that they were imposed in what
was supposed to be the country of free
enterprise.
The same paradox was apparent in
telecommunications. The deregulation
movement in telecom, with economists
at the forefront, also started in the 1970s.
First, AT&T was broken up into regional
entities by the Antitrust Division of the
U.S. Justice Department. Litan properly
criticizes AT&T’s longtime monopoly
and the ongoing power that the regional
“Bells” have over the “local loop,” but he
does not emphasize enough the paradox
that these monopolies were creatures of
government itself. Also in the telecom section, he discusses the partial deregulation
of the electromagnetic spectrum that got
underway in the 1990s with the auctioning
of frequencies by the Federal Communications Commission. The idea for those auctions had been advanced by Ronald Coase
three decades earlier in work that would
help earn him the Nobel Economics Prize.
The attentive reader of Trillion Dollar
Economists will notice that the economists
credited for innovations were often not
holders of economics Ph.D.s, but instead
were statisticians, mathematicians, engi-
40 / Regulation / Spring 2015
in review
neers, and others who “[think] like economists.” Yet economics remains essential.
The advance of Big Data has made empirical work easier, but theory has become even
more necessary because aimlessly fishing for
data easily leads to misleading correlations.
Regulation /
Litan is careful not to blame
the Great Recession on economics or
finance. He recognizes that “politicians
promoted home ownership” and thus
they deserve much of the blame for the
real estate bubble and subsequent collapse.
But he is still too soft on the federal government. He thinks that financial regulators did not regulate enough prior to the
recession; they “got too cute, or too complicated.” He believes that government can
and should manage the macroeconomy.
He is persuaded that “Bernanke’s extraordinarily innovative easy-money policy
helped save the U.S. economy from a far
worse recession than actually happened.”
Perhaps blinded by the limited experience of deregulation of the last decades of
the 20th century, Litan seems to overlook
the generally growing trend of regulation.
Since the end of World War II, the Code of
Federal Regulations (which annually consolidates all existing federal regulation) has
grown from less than 20,000 pages to more
than 130,000; state and local regulations
have also mushroomed. Even with the
late-20th century deregulation era, overall
government regulation has continued to
grow. (See my “A Slow-Motion Collapse,”
Winter 2014–2015.)
Consider finance. It is true, as Litan
argues, that some deregulation occurred—
brokerage commissions were decontrolled,
for example. But the whole industry is
quite certainly more regulated today than
at any time in American history. Even
before the Great Recession, the regulatory burden was heavy; for example, the
New York Fed had hundreds of regulating
bureaucrats working on the very premises
of large banks. Regulation has become so
omnipresent that we do not see it anymore.
Nor, seemingly, does Litan. He is sympathetic to cryptocurrencies but he does
not seem to realize that they are being
crushed by regulations (many emanating
from the war on drugs). He explains well
the efficiency of prediction markets (they
predicted the 2004 presidential election
better than opinion polls) but is soft on the
government’s attempts to regulate them
out of existence, including with the DoddFrank financial legislation. He seems to buy
wholesale the necessity of antitrust laws.
Litan is an intelligent and well-informed
economist. He knows his classics, from “the
great Austrian economist Friedrich Hayek,”
to Milton Friedman, not to forget Joseph
Schumpeter and Israel Kirzner. He is familiar with public choice theory. He generally
believes in the efficiency of markets: “the
alternative to allocation by price is allocation by queue.” He is well aware of the disagreements among economists, including on
redistribution, even if he himself favors it for
equity reasons and as “a form of social glue.”
And he understands that in a free economy,
what matters is the satisfaction of consumer
demand, not the success of producers.
Values and analysis / I find in Trillion Dollar Economists the same disquieting contrast I contemplate every week in reading
The Economist. (Interestingly, the review of
Litan’s book in The Economist blames him
for being too obsessed with economic efficiency.) On the one hand, one sees a generally good understanding of markets and
their efficiency. On the other hand, one
is struck by a constant deference toward
those who run the government and interfere in markets. How can they miss that
inconsistency? Or is it just me?
The problem is, no doubt, partly attributable to differences in values. Contrary
to my view, Litan, like The Economist, is
willing to call on government coercion
to skew in favor of different people the
distribution that would otherwise result
from the working of free markets. In their
perspective, there exists some public goal
or purpose to which individual ends must
be subordinated, but they realize that this
subordination is done at a lower cost if the
market is put at the service of public policy
instead of being crushed. This approach
is very different from the classical liberal—
or, at any rate, the libertarian—approach
where only individual preferences, goals,
and happiness matter.
But, contrary to what Hayek argued, libertarians and socialists probably also have
analytical differences besides differences
in values. One such analytical disagreement lies in the social democrats’ belief in
the omnipresence of market failures. The
fact that Litan was at one time “principal
deputy assistant attorney general” in the
Antitrust Division reveals something not
only about how embedded he was in the
monstrous federal bureaucracy, but also
about his belief that economic freedom is
impossible without constant government
threats and meddling. In this perspective,
the mildest conditional prejudice in favor
of some economic freedom looks like freemarket ideology. How else could we understand his claims that the George W. Bush
administration was “a Republican administration committed to free markets”?
Another sort of analytical disagreement
is probably traceable to the influence of
John Maynard Keynes. It is true that Litan
shows some skepticism toward macroeconomic management. But he seems to agree
that a free-market economy is inherently
unstable, as if any other economic system
were better. In a more general way, I suspect
that Litan would agree with Keynes that, in
a society that “thinks and feels rightly”—a
society where, probably, the government
regularly consults him—politicians and
bureaucrats can be trusted to take risks
with other people’s liberty.
Trusting government /
The author of Trillion Dollar Economists does not distrust government. He talks fondly of “government
service” and “public service.” He does not
appreciate that political solutions are generally more risky than the market failures
they are (officially) meant to correct. Information asymmetries are potentially more
damaging in the political market, where
bureaucrats use the information they control to manipulate politicians while the latter use their own privileged information to
defraud citizens. Litan argues that a carbon
tax or a cap-and-trade system “is really a
Spring 2015
matter of prudence,” but he forgets that
protecting citizens against Leviathan is a
much more serious matter of prudence.
Another sort of reason why our trust
in government should be very limited lies
in the fuzziness of the very notion of public interest. Society is the locus of private
interests resulting from individual preferences that cannot be aggregated into nondictatorial “social preferences.” Government action nearly always overrules some
individuals’ preferences in favor of other
individuals’. On the contrary, Litan believes
that “the best interest of society as a whole”
requires constant attention and meddling
with cost-benefit analysis. Perhaps, like
many economists, he has just not thought
through issues of social choice and welfare
economics, but he should have.
The reader of Trillion Dollar Economists
will appreciate that Litan has worked with
many of the most important economists
of our time, but the name-dropping gets
a bit tiresome. Everybody seems to be his
“good friend.” Is there any liberal economist with whom Litan has not rubbed
elbows? Perhaps he is just a sociable guy
who has problems finding faults with his
fellow citizens. But he may also be much
too close to the establishment.
As any author knows in his bones,
nothing is perfect. If a good book is a
book in which one learns something, Trillion Dollar Economists is a good one for me,
both for what it contains and for what it
underplays.
Peter Wallison Dissents
Again, with Feeling
✒ Review by Vern McKinley
E
ver since it became clear in 2008 that we were in the midst of
a financial crisis, we have been hearing dueling narratives over
who or what was primarily to blame for the crisis: either greedy
capitalists or government housing policy.
One of the most important voices in this dispute has now weighed
in with the book Hidden in Plain Sight.
Since the late 1990s, Peter Wallison of the
American Enterprise Institute has been
one of the most prolific commenters on
the build-up of the housing bubble, the
ensuing financial crisis, and its underlying
cause. Back in the late 1990s, long before
most people understood precisely what
Fannie Mae and Freddie Mac did, he was
raising red flags (including several articles
in these pages) and warning that the market and political dominance of the pair
would one day end badly.
Wallison was a member of the Financial Crisis Inquiry Commission (FCIC),
the 10-member body that was tasked with
V er n McKinley is a visiting scholar at the George
Washington University Law School and author of Financing
Failure: A Century of Bailouts (Independent Institute: 2012).
examining the causes of the crisis, among
other duties. The final report of the FCIC
split along partisan lines, with the six
Democratic Party members supporting
the final report and the four Republicans
dissenting. Wallison distinguished himself
as a lone dissenter with his arguments that
government housing policy was at the core
of the causes of the financial crisis.
In 2013 AEI released his book Bad History, Worse Policy as an initial response to
the FCIC majority’s findings. However, the
book was simply a re-release of multiple
policy pieces he had penned from 2004 to
2012, with some limited explanatory text
integrated in. Hidden in Plain Sight, on the
other hand, is all original writing, albeit
citing much of the same source materials
he has cited over the years, organized into
/ Regulation / 41
a coherent summary of his arguments on
the precise cause of the crisis. The depth of
the research in the book is nothing short of
extraordinary as he addresses all the potential causes, provides an amazing number of
on-point documents to support his thesis,
and responds to the arguments of his critics who cling to the idea that government
housing policy played no or only a small
role in the crisis.
/ Wallison’s first
chapter sets forth the overarching arguments that he develops later in the book:
Government and NTMs
The financial crisis was the result
of the government’s own housing
policies or, more precisely, “the crisis
would not have occurred without
those policies.”
■■ The “seeds of the crisis were planted in
1992” when Congress enacted affordable housing goals for Fannie Mae and
Freddie Mac, the government-sponsored enterprises (GSEs) that purchased loans in the secondary market.
■■ Fannie and Freddie reduced their
underwriting standards not only with
regard to low-income borrowers, but
also to high-income borrowers.
■■ Because of the deterioration in
underwriting standards, by 2008 half
of all U.S. mortgages were “subprime”
or “Alt-A,” which means they were of
below-prime quality (more on this
below). Some 76 percent of the lowerquality loans were held on the books
of government agencies or the GSEs.
■■ The GSEs did not disclose the full
extent to which they held such lowerquality loans.
■■ When the bubble deflated, the financial
crisis put at risk many of the largest
financial institutions in the country.
■■
Right out of the box after laying out his
thesis, Wallison digs down into the data to
support his core arguments, and his use of
data, tables, and graphs bolsters his arguments throughout the book. The source of
the data is research demarcating traditional
and non-traditional mortgages (NTMs)
undertaken by Edward Pinto, an AEI col-
42 / Regulation / Spring 2015
in review
league. Traditional mortgages adhere to
standards as adjudged under three key elements: a loan-to-value ratio of 90 percent
or less, which indicates a material down
payment; a debt-to-income ratio of 38 percent or less, which indicates the amount of
a borrower’s income committed to debts;
and a borrower’s credit record, which is the
history of the borrower’s meeting of prior
debts and should indicate no late payments
(or, in rare cases, one). An estimated 85 percent of sampled loans met those standards
between 1988 and 1991.
Growth in the segment of the market dedicated to NTMs—what Wallison
derides throughout the book as “flexible”
or “innovative” lending standards—was
a good indicator of the deterioration in
credit standards. At bottom, Pinto estimates the number of troublesome NTMs
outstanding as of mid-2008, just at the
onset of the major stress and panic of the
financial crisis in the fall of 2008. Under
Pinto’s analysis, the NTMs numbered 32
million of the total (balance of over $5 trillion) or 58 percent of the total 55 million
U.S. mortgages as of mid-2008. Government agencies as a group were exposed to
76 percent of the NTMs, with Fannie and
Freddie exposed to over half. Those data
are especially significant because Fannie
and Freddie did not begin to report their
full exposure to NTMs until after they were
taken into conservatorship by their regulator, the Federal Housing Finance Agency,
in 2008. As a result, “analysts, regulators,
academic commentators, rating agencies,
and even the Federal Reserve were seriously
misled about the scope of the NTM problem, believing that it was much smaller,
and the number of traditional prime mortgages outstanding was much larger, than
in fact they were.”
Finding what they wanted to find /
Wallison
settles a few scores with those who have
criticized his analysis over the years (primarily those he derisively refers to throughout the book as being “of the left” or “on
the left”) or that came to different conclusions than he did regarding the genesis of
the crisis (primarily his fellow commission
members and select staff of the FCIC). Wal- Federal policy / Wallison traces through
lison holds those “on the left” in greatest an exhaustive review of the history of the
contempt and ire, noting that “they have build-up of the bubble, from the state
no data, no policy arguments, just a viru- of housing finance before the affordable
lent denial that anything other than the housing goals were implemented; the
private financial sector could possibly be ratcheting up of the goals; the political
calculations regarding taking credit for
responsible for the financial crisis.”
Turning his attention to the FCIC, the homeownership increases (both during the Clinton and George
official arbiter of the causes
W. Bush administrations);
of the crisis, he cites a range
through the steady deterioraof sins visible to him as an
tion of credit standards durinsider to the process: just
ing the 1990s and how that
one staff member from a total
ultimately precipitated the
staff of almost 80 was procrisis. The breadth of research
vided to support the minorthroughout this history is
ity’s research; the executive
incredible, including matedirector was on loan from the
rial from a Federal Housing
Federal Reserve and thus was
Authority underwriting manpotentially conflicted in her
ual from the 1930s; internal
investigation of that agency’s
Housing and Urban Developrole in the crisis; the chair
of the commission did not Hidden in Plain Sight: ment Department memos,
What Really Caused
reports, speeches, and testisolicit the views of the minor- the World’s Worst
mony; homeownership stratity or keep them informed on Financial Crisis and
details of the FCIC investiga- Why It Could Happen egies; and Fannie and Freddie
10K and 10Q reporting.
tions; and Pinto’s work was Again
One truly unique chapter
never formally made available By Peter J. Wallison
386
pp.;
Encounter
in the book is on fair-value
to the other members of the
accounting and its role in the
FCIC and the majority essen- Books, 2015
dissemination of information
tially dismissed his research
regarding the financial posiout of hand.
I have always been of the opinion that tion of financial institutions. I don’t recall
the FCIC’s report included some useful any other book on the financial crisis going
information and that the interviews it into such detail on this issue and it is an
conducted and the never-before-released excellent summary of the topic. A discusemails it made available were some of the sion of each of these historical issues and
few avenues to get detailed information related documents cannot be undertaken
out of the financial agencies (which were in this brief book review, but Wallison
not willing to release much information always seems to find just the right docuvoluntarily). But Wallison’s conclusion mented evidence to support his argument.
The last section of the book details the
about the politicization of the FCIC’s
government response to the crisis, or what
policy conclusions seems about right:
Wallison calls the “panic and bungling of
As far as I could tell from the witness
the officials who handled it. Then, in trying
interviews I was able to get, no one
to minimize or justify their own mistakes,
conducted any cross-examinations, and
these officials claimed that they had insufno one used any documents to question
ficient authority to deal with the crisis.” He
the witnesses’ statements or otherwise
walks through a number of the narratives
test their veracity. The process simply
put forth by the authorities to justify their
validated the conventional view of the
response. The interconnectedness fallacy
financial crisis that the media had
that was used to justify the bailout of Bear
already accepted and repeated.
Stearns? He rightly speculates that it was
Spring 2015
“dreamed up in either the Federal Reserve
or the Treasury to justify saving Bear Stearns, and it was easily swallowed by the
media at the time.” The Federal Reserve’s
authority to rescue Lehman? “It does not
take much detailed analysis … to find that
the story Paulson and Bernanke used to
explain their failure to rescue Lehman has
no basis in fact.” The dramatic zigs and
zags of different and inconsistent policy
responses? “Instead of a sense that the U.S.
government knew what it was doing and
had settled on a policy, there was now a
sense that the government was winging it
or simply incompetent.”
I believe this will be one of the best
policy books of 2015, and one of the best
books on the crisis since it ended. For readers who have been critical of government
housing policy and response to the crisis,
Hidden in Plain Sight will provide you with
more ammunition than you can ever hope
to use. For readers who bought into the
narrative of the media and the FCIC and
are in denial that government policy caused
the crisis, get ready to become so frustrated
by Wallison’s mountain of contrary evidence that your head may explode.
/ Regulation / 43
and even maintenance of the existing capital. The population began to decline, as
did the median income. Curley’s political
success came at the price of setting his city
on a downward spiral.
Boston kept sinking until Massachusetts voters enacted a property tax limitation measure, Proposition 2.5, in 1980. The
measure had been frantically opposed by
both city and state politicians because they
were certain that tax limits would “starve”
the city. But instead of starving Boston,
Prop 2.5 breathed life into it. Ambitious
people and investment quickly returned.
Walters emphasizes that Boston’s
revival didn’t occur because politicians had
solved any of the usual problems that are
blamed for urban decay: racism, poor education, crime, and so on. All that changed
✒ Review by George Leef
was a tax limitation measure that kept Boston from strangling itself with high taxes.
Is that a unique case? No; the same scehy are some American cities thriving, growing in populanario has played out in quite a few other
tion, investment, and incomes, while others are in decline cities and San Francisco is a good example.
with shrinking populations, crumbling buildings, and “Progressive” politicians there had played
businesses fleeing?
the same redistributive game as Curley
For the answers, read Boom Towns by Loyola University Maryland in Boston, with the same results. By the
economics professor Stephen Walters. imposing high property taxes. The wealthy 1970s, San Francisco was a dysfunctional
Based on his years of study of cities, he owners will have no choice but to pay and the mess, mainly because of militant unions
concludes that the key to a successful city increased revenues can be used for projects that kept striking for higher pay, which
is to protect property rights and otherwise and programs most of the voters like. These the politicians funded with higher taxes.
leave people alone. “The record is clear,” programs can also help to buy favor with
But in 1978 California voters passed
he writes, “cities grow and prosper when important interest groups.
Proposition 13, despite Calithey encourage the formation of capital
fornia liberals’ declaration
in its many forms by securing the returns Boston and San Francisco /
that it would be utterly ruinOne of America’s most notothat flow from it.”
ous. Almost immediately,
What causes cities to go into decline is rious practitioners of the
capital began flowing back
equally clear: it happens when government redistributive strategy was
into San Francisco and other
stops protecting property rights. People Boston mayor Michael Curcities in the state. As Walters
and capital don’t stay where they are poorly ley, who governed the city for
writes, “Prop. 13 increased the
treated. Walters strongly argues his the- four nonconsecutive terms
return on investments and
sis with cases showing the various ways (between terms in Congress,
protected [investors] against
politicians—often in league with private the governor’s mansion, and
further Robin Hood raids.” As
prison) between 1914 and
interests—have turned growth into decay.
with Boston, San Francisco’s
Probably the most widespread threat to 1950. The masses adored this Boom Towns:
revival had nothing to do with
a city’s continuing success is redistributive “man of the people” who kept Restoring the Urban
the discovery of “solutions” to
American Dream
taxation. Accumulated wealth in the hands increasing property taxes on
any of the presumed causes of
of business people and professionals is a the rich, but few could see the By Stephen J. K.
urban decay.
Walters
tempting target for politicians who figure slow-motion deterioration
210 pp.; Stanford Busithey’ll gain far more votes than they’ll lose by of the city produced by his ness and Finance, 2014 Baltimore and Detroit / Baltimore serves as an instructive
redistributive policies. High
George Leef is director of research at the John W. Pope
Center for Higher Education Policy.
case for precisely the opposite
taxes repelled new investment
Property and Cities
W
44 / Regulation / Spring 2015
in review
reason. It’s a city where there has never been
a reduction in taxes. For decades, city leaders have placed their bets on big, splashy
government-led projects to revive it, but
those “investments” have been failures.
Walters writes about one of them, the
Charles Center development: “Upon its
completion in the early 1960s, press coverage was adulatory and opinion leaders
praised those behind the thirty-three-acre
project for their good intentions, brilliant
vision, bold artistic sense, and deft political
touch.” Over the decades, city officials kept
pouring money into similar “renaissance”
projects, but “few noticed that [Charles
Center] is actually a failure both within its
borders and beyond them.”
Because of the high-tax, governmentcentered philosophy that has held sway
in Baltimore (and the state of Maryland),
most of the city is decaying. Instead of
encouraging small capital investments that
really would radiate jobs and prosperity,
city officials have tried to use big government as a catalyst, and failed. Baltimore’s
unhappy experience strongly supports
Walters’ overarching point that cities do
well when spontaneous, bottom-up development is not discouraged and they do
poorly when politically planned, top-down
development takes over.
Redistributive taxation isn’t the only
way that cities turn against the sources of
prosperity. Another is to embrace the union
movement, whose short-sighted actions
siphon away a large portion of the return to
invested capital and thereby set in motion
private responses that slowly de-capitalize
a city to the detriment of nearly everyone.
Detroit is, of course, the prime example.
Walters gives readers an intriguing history of
the city that became the center of the auto
industry. It grew at a dazzling pace from 1900
to 1950, by which time it was the nation’s
fourth-largest city, boasting a median family
income second only to Chicago. A true boom
town, the good wages available in its many
industries attracted people of all races.
During Detroit’s fabulous growth,
unions represented no more than 10 percent of the workers in the city’s many factories—a strong refutation to the frequently
only a little at the margin. But the right-towork law is a signal that public policy is not
dominated by the redistributionists, and
that is a very important signal.
Speaking of signals, a bad one that cities
can send is that they are willing to use eminent domain to seize property from homeowners and small businesses, and redistribute that land to big companies. Walters
writes that there has been a “hundred-year
war” between eminent domain and private
property, with private property constantly
in retreat. When cities
play that game, he writes,
For decades, Baltimore leaders have
“The mere threat of such
bet on big, splashy, government-led
takings will have a chillprojects to revive the city, but
ing effect on private owntheir “investments” have been failures.
ers’ plans to upgrade residences and businesses in
areas targeted for ‘rescue’
intriguing back-story on the reason for by planners.” Also, eminent domain–based
Henry Ford’s capitulation.) Unionism now development tends to misallocate capital
seemed to be an easy way for workers to get because it distorts price signals and substitutes the tastes of the planners for those of
higher wages and it spread rapidly.
The long-run effect of the alliance market participants.
Another way cities can damage thembetween unions and politicians was similar
to high tax rates. Investors stopped putting selves is by caving in to “green” interests.
money where the returns were expropri- Portland, Ore., is the best illustration, with
ated. Between 1947 and 1958, manufactur- its Urban Growth Boundary. The ratioing employment fell by 40 percent; Detroit nale behind the meddlesome law is that
went into a tailspin from which it has never saving space for nature is so important
recovered. Although Walters does not cite the that the city’s growth has to be walled in.
work of economist W. H. Hutt (his 1973 book The consequences might please the enviThe Strike-Threat System [Arlington House] ronmentalists, but affordable housing for
in particular), his argument dovetails with lower-income families has disappeared.
Boom Towns is full of helpful ideas for
Hutt’s that unions can only exploit capital
in the short-run, after which it departs for officials who would rather preside over a
growing, increasingly prosperous city than
greener pastures. Detroit is proof of that.
one they could milk for short-run political
Inviting signals / Walters includes an analbenefits. For example, Walters focuses on
ysis of the effects of right-to-work laws. the pro-competition, pro-market policies
He argues that they mainly are a signal to implemented by a line of mayors in Indiabusinesses that they will find a welcom- napolis, which is one of America’s most
ing climate. States that allow compulsory successful big cities.
unionism hurt their cities’ ability to comUrban theorists in the “progressive” trapete for investment by sending the oppo- dition insist that the problems that plague
site signal. I think he’s correct.
our cities can only be solved through masBy themselves, right-to-work laws don’t sive infusions of government money and
change matters much. They can’t forbid expert planning. Walters’ book persuasively
unionization, but only allow workers to makes the opposite case: protect people’s
refuse to pay union dues. That doesn’t save property rights, then leave things to the
companies any money and costs the unions spontaneous order of the free market.
made claim that unions created America’s
middle class. But that was in the days when
unions were treated no differently than
other voluntary organizations under the
law. That changed with the enactment of
the National Labor Relations Act in 1935
(upheld against constitutional challenge
by the Supreme Court in 1937).
The United Auto Workers promptly
used their muscle to organize General
Motors and Chrysler in 1937; Ford held
out until 1941. (Walters provides the
Spring 2015
You Had Me at Page One
✒ Review by David R. Henderson
“I
’ve always had trouble succeeding along traditional Bush family lines.” So writes Jonathan Bush on p. 1 of his book, Where
Does It Hurt? With that one sentence, he had me. Bush is a
nephew of George H. W. Bush and a cousin of George W. Bush. I’m not
a fan of politicians and those two, especially George W., rank low on my
list. So when a Bush tries to make it in the
private sector rather than in government,
I’m already somewhat of a fan.
Of course, Jonathan could have blown
it by having nothing important to say in
his book. But on the nuts and bolts of
health policy, and even on what his uncle
called the “vision thing,” he has a lot to say.
I have been around health
economics a long time, having
been the senior economist for
health policy at the Council
of Economic Advisers under
Ronald Reagan from 1982 to
1984. I’ve tracked the issues
since then, and so I’ve read a lot
of health care studies. Bush’s
book, co-authored with Stephen Baker, is one of the best
I’ve seen in a long time.
new markets.” That last sentence got me
thinking back to Austrian economist Israel
Kirzner’s discussions of “entrepreneurial
alertness.”
In this digging, Bush does not disappoint. In chapter after chapter, he and
Baker not only show how dysfunctional the
health care system is, but also discuss ways
that entrepreneurs can make
it better. For example, after
noting that a magnetic resonance imaging scan (MRI)
at Massachusetts General
Hospital would be billed at
$5,315 to an insured patient,
Bush runs the numbers and
concludes that a business
that did three images an hour
and was open 12 hours a day
could charge $99 per MRI
and make huge profits.
Entrepreneurial alertness / Where Does It Hurt?
He goes beyond such stoBush is cofounder and CEO By Jonathan Bush with ries of possibilities and tells
of Athenahealth; Baker is a Stephen Baker
of actual successes. A doctor
224
pp.;
Portfolio/
former senior writer for Businamed Arnold Milstein, for
ness Week. They bring a deep Penguin, 2014
example, had worked with
appreciation of the entreUnite Here, a union reprepreneur to their analysis of
senting Las Vegas hotel and
health care. “Entrepreneur” and “health casino workers. After analyzing the data, he
care” in the same sentence? Really?
eliminated the most expensive 10 percent
Yes, really. They write, “From an entre- of doctors from the union’s health plan,
preneur’s point of view, there’s something resulting in a $55 million reduction in
highly appealing, almost intoxicating, health care expenditures. Amazingly, many
about waste and dysfunction in the indus- of those doctors picketed the hotels where
try.” They continue, “Those who can dig the union members worked! Milstein
down through the morass of rules, paper- believes that the $55 million reduction
work, and bureaucratic obstacles can find was due partly to the disciplining effect
on the doctors who remained in the plan.
Dav id R . Hender son is a research fellow with the
Hoover Institution and an associate professor of economics
And after being stuck at $13 an hour for
at the Graduate School of Business and Public Policy at the
Naval Postgraduate School in Monterey, Calif. He is the
the previous few years, the workers’ average
editor of The Concise Encyclopedia of Economics (Liberty Fund,
2008). He blogs at www.econlog.econlib.org.
wage rose by $1.10. This shouldn’t be sur-
/ Regulation / 45
prising because, as economists well know,
the cost of benefits is borne largely by the
beneficiaries in the form of lower pay.
Birthin’ babies / Bush’s first big entrepreneurial venture was in birthing. He calculated that more extensive use of midwives
could save a lot of money and that if he set
up a string of birthing centers, he could
split the gains with insurers. So he and a
business partner named Todd Park started
Athena Women’s Health and set up some
birthing centers in San Diego, with the
plan of ultimately going national.
The system worked—for the pregnant
women. Bush writes:
Only 10 percent of our births were delivered by C-section, about one-third of
the national average. Ninety percent of
the mothers who gave birth in our centers breast-fed their babies, compared to
the 67 percent national average at the
time. (Now it’s close to 80 percent.) We
avoided the common widening incisions
called episiotomies, which are expensive,
horribly uncomfortable for the mother,
and statistically counterproductive.
Unfortunately, it didn’t work for
Athena. Why? Their popularity hurt them.
Such is the weird structure of health care
and health insurance. Bush writes:
It was the opposite of the way a sane
market operates. Because we were popular, we attracted customers for what
to most women is the most expensive
medical procedure of their pre-Medicare
years. Increasingly, health plans that
offered Athena would receive three or
four months of premiums and then pay
claims that averaged $12,000—and then
lose the customer. The insurers began to
view us as toxic. A s**t magnet. Growing numbers of health plans fired us by
kicking us out of their networks.
The result: most of their remaining clients
were on Medicaid or were uninsured and
paid cash.
What Bush doesn’t tell you, perhaps
because he doesn’t know, is that in a world
without insurance regulation, Athena
46 / Regulation / Spring 2015
in review
probably would have made money. Why?
Because without insurance regulation,
most insurers would probably not have
covered delivery, and people who wanted
babies would have paid for birthing
directly. As actuaries can tell you, for
something to be an insurable event, it
must typically have two characteristics:
large loss and low probability. Because
delivering a baby is expensive, the first
criterion is covered. But in this era of
birth control and legal abortion, a very
large percentage of pregnancies brought
to term are planned. So baby delivery
does not fit the second criterion. Insurers started to cover it in states in which
the state government required such coverage. Insurers not in those states started to
cover it only when the federal government
started requiring it in employer-provided
health insurance with the Pregnancy Discrimination Act of 1978. Without that
law, most people would do what my very
modest-income parents did: save money
to pay for delivering a baby. Under that
model, Athena might have been a roaring success.
Beyond birthin’ babies / Of course, that
decades-old law was not something that
Bush could change, even had he known
about it. But, true entrepreneur that he
is, he realized his mistake.
In building the business, Bush’s firm
had developed software to help the company get paid by insurance companies.
Specifically, Park’s brother Eddie built
software that incorporated each insurer’s
idiosyncratic rules. The software worked
well. A venture capitalist to whom Bush
was appealing for funds to save his birthing business cut him off. “I’m not interested in your birthing business,” he said.
“But I can get you $11 million for rights
to your software.”
So Bush’s company pivoted. In 1999,
when the dot-com boom was at its height,
“the new Athenahealth was reborn as an
Internet company.”
Put the Uzi away
/ The company moved
back to the Boston area and did great,
even after the dot-com bust. But there was
one fly in the ointment: President George
W. Bush. Jonathan writes, “My cousin,
the forty-third president of the United
States, was about to sign a bill that could
destroy us.”
How? A long-time “antikickback law”
prevented hospitals and doctors “from
exchanging services, information, or
products of value with each other,” considering all such exchanges to be unethical. In 2004, a bill started working its
Care Act.” Kocher went all Milton Friedman on the skewed incentives in the medical system that existed before the ACA
and then admitted that the ACA didn’t
do much to make that better. I wish that
Bush had asked him whether he thought
the ACA made it any better.
Unfortunately, amidst all his great
insights and stories, Bush forgets everything he learned on his trip to Washington and wimps out. “I don’t intend,” he
writes, “to spend this chapter pounding
on the government, or
proposing a rapid shift
A single detail in a law, he writes, “can
to a private health care
throw lives or entire companies into
economy.” While, to his
a tailspin.” Elsewhere he writes,
credit, he wants “only a
“Government is like a giant with an Uzi.”
fraction” of the regulations we have today, he
does want “smarter”
way through Congress that would give regulations.
“safe harbor” from that law to hospitals
He does understand that the more comso that they could provide doctors with petition there is in health care, the better.
digital technology. But it didn’t give safe How do you get more competition? One
harbor to hospitals that bought Internet way is to get more insurance companies in
services.
the business. But he claims that this “is one
So Bush flew to Washington to lobby area where the government could help, perCongress. It won’t surprise anyone who haps the way it does with Fannie Mae and
has seen complex laws being made that Freddie Mac in real estate.” Really? Because
few members of Congress even knew what Fannie Mae and Freddie Mac worked so
was in the bill. In the office of Rep. Nancy well? Say it ain’t so, Jonathan.
Johnson (R–Conn.), chair of the health
There’s a much more straightforward
subcommittee of the House Committee way to get more competition in insuron Ways and Means, Bush watched the ance, and it’s one of the few good ideas
congresswoman page through the bill and that many of the Republicans had durfind the relevant section. He pointed to ing the ACA debates of 2009 and 2010:
where it said “computers and software” allow people to buy insurance across state
and asked her to add “and Internet ser- lines, with the rules dictated by the state in
vices.” He writes, “She did.”
which the insurer is located. This is done
Bush got to see the ugliness of govern- with credit cards now, which is why it’s
ment up close. A single detail in a law, he so much easier to get a credit card than it
writes, “can throw lives or entire compa- was in the early 1970s. Such a solution is
nies into a tailspin.” In one of the most not only good economics but also good
memorable lines in the book, he writes, federalism. State governments should not
“Government is like a giant with an Uzi.”
be able to restrict interstate commerce.
I was disappointed that, although Bush
Conclusion / There is so much more of
earlier had recognized the problems with
value in the book. One striking section state regulation of interstate commerce, he
is five pages of excerpts from a conversa- failed to apply that insight here.
tion that Bush had with Bob Kocher, who
Still, this is a great book. I’m glad that
“worked for the Obama administration Jonathan chose his career rather that of his
and wrote most of the original Affordable uncle and cousin.
Spring 2015
Do Good Names Bring
Great Riches?
✒ Review by Art Carden
S
ome great artists work with oils. Some work with stone. Gregory
Clark works with data. The Son Also Rises is an excellent example
of careful and creative inference from an incomplete historical
record, namely the history of family social mobility.
Clark offers detailed studies of the modern United States, modern
Sweden, medieval and modern England,
India, China, Taiwan, Japan, Korea, and
Chile to show that patterns of social
mobility are remarkably similar across
societies. He deals with exceptions and
anomalies toward the end of the book, and
while there are unanswered
questions and clear directions for further research, his
treatment of the subject is
impressively comprehensive.
widely in their institutions—from modern
Sweden to medieval England to Maoist
China—exhibit remarkably similar patterns
of social mobility: slow regression to the
mean over generations. His findings are
robust to different measures of status like
income, education, and representation in high-status professions like law and medicine.
He explores this empirically
by looking at the changing
positions of surnames across
Track i ng s u rn a m e s / He
different markers of status
diverges from the usual
(income and education, for
studies of social mobility
example) for different societby using a novel approach.
ies. The surname Pepys, for
He “estimates social mobilexample, is over-represented
ity rates by measuring the
in the medical field and
rate at which surnames that
in Oxford and Cambridge
The Son Also Rises:
originally had high or low Surnames and the His- admissions, though ironisocial status lose that status tory of Social Mobility cally the most famous Pepys
connotation.” That idea was By Gregory Clark,
of them all—Samuel Pepys, the
inspired by a New York Times with Neil Cummins,
diarist—left no heirs.
reviewer of his 2007 book Yu Hao, and Daniel
Clark argues for “a law of
A Farewell to Alms (Princ- Diaz Vidal
social mobility” whereby a
eton University Press). Clark 364 pp.; Princeton
family’s position in society is
University Press, 2014
does this by assembling a
determined by its members’
wide range of data sources
underlying “social compeand looking to see whether
tence.” It is an attractive and
names that appear in high-status probate intuitive theory, but while this is distinct
records and income tax lists later appear from inherited wealth or inherited ability,
among lists of people in high-status occu- he nowhere defines exactly what this social
pations (like doctors and lawyers), lists of competence is. At this stage in the research
students enrolled at elite universities, and program, “social competence” is an X facother measures of status.
tor (literally—see the equation on p. 125)
One of his most impressive contribu- that explains trends in social mobility but
tions is his finding that societies differing that so far remains undefined and unmeasured. Rather, it is inferred from the patArt Car den is an assistant professor of economics in the
Brock School of Business at Samford University
terns Clark identifies in the first half of the
/ Regulation / 47
book for Sweden, the United States, and
England and then tests in the second half
of the book for India, China, Japan, Korea,
and Chile. He claims to have discovered
an element of “social physics” governing
social mobility over time. If we may extend
the analogy to the physical sciences, “social
competence” is his Higgs Boson: predicted
by the theory and essential to the argument, but not actually observed.
The story would be much more complete if he had defined and described social
competence in greater detail, but this failure is an opportunity for further research
rather than an irremediable flaw in his
overall argument. Social competence will
necessarily be a moving target, dependent
on economic, political, social, and cultural
contexts in society that are always shifting. Identifying the characteristics of the
highest status people in a particular data
set and then constructing a social competence index that measures a family’s social
competence as a weighted average of the
differences between a particular family
and the highest-status family strikes me
as something Clark could try, but such a
measure is likely beyond the capacity of currently available data (and, for me, certainly
beyond the capacity of a book review).
Resistant to manipulation / People who
appreciate the dismal aspects of economics will welcome some of the book’s conclusions. First, social mobility patterns
are basically the same across the societies
Clark studies and are stubbornly resistant to attempts to create new societies
through social democracy (as in Sweden) or violent communist revolution
(as in Mao’s China). Second, attempts
to redress historical injustices through
programs like the reservation system in
India that reserves spots in universities
and public jobs for people from historically oppressed castes actually work to the
detriment of the poorest people in society.
Clark’s work suggests there is more than
political will standing in the way of greater
social mobility.
It is not clear, however, that social
mobility should be at or near the top of
48 / Regulation / Spring 2015
in review
the public policy agenda. In a rhetorical
flourish, he refers to the bottom of a society as a “squalid netherworld.” If incomes
and educational opportunities up and
down the rungs of the social ladder were
fixed, then social mobility would be a cause
for great concern; that a person could be
mired in a squalid netherworld through
nothing more than an accident of birth
offends many people’s sensibilities.
Incomes and educational opportunities are not fixed, however, and there is no
reason the bottom of the income status
distribution should be squalid or a netherworld. In a growing economy, people up
and down the income distribution will
have more and better opportunities for
flourishing and self-authorship even if we
hold the income distribution fixed and
completely eliminate social mobility. If
people are confronted with ever-expanding
opportunities to obtain food, clothing,
shelter, and enlightenment, I don’t see why
we should treat social mobility as an issue
that requires corrective public policy even
if we could do something about it. This
isn’t to say that people should accept that
they are like George Lucas’s droids or Akira
Kurosawa’s peasants—“made to suffer”—
but it isn’t clear that desire for status is a
morally praiseworthy trait or a legitimate
demand upon society.
Our demand for status raises another
important issue that was not necessarily
germane to medieval English peasants and
lords, but that is becoming more important with the rapid improvement and diffusion of communications technology. We
get to choose our own “societies” in ways
that were impossible to previous generations. This isn’t just because we can sort
into political jurisdictions that best match
our preferences with our constraints. The
Internet has given us the ability to join or
even form an infinite array of new societies.
At the margin, the physical, material, and
political societies in which we live become
less relevant when we can choose to spend
less time interacting with a society centered
around geography (say, people who live in
the United States) in order to spend more
time interacting with a society centered
around common interests.
Here’s an example: Andrew Reams
is one of my 6-year-old son’s heroes. To
most people, Reams is just a guy who
lives in Roanoke, Va. To people like my
son who love elevators, though, he is YouTube celebrity “DieselDucy,” who takes
followers on tours of landmark elevators,
carwashes, arcades, and other mechanical
marvels. People have always had hobbies
and have always sought out others with
common interests, but the Internet has
made it much easier for people to craft
their own societies centered around common interests or common networks. For
instance, Reddit contributors who earn
more “upvotes” than “downvotes” for
their submitted links and comments earn
“karma” that cannot be redeemed for anything, but that measures one’s standing
within that community. The caption on
one of my favorite xkcd cartoons reads,
“Human subcultures are fractally nested.
There is no bottom.” As better communications technology makes it easier for new
subcultures to emerge, it will be interesting
to see the degree to which people value
status within the different “societies” to
which they belong. And in 2115, I expect
that one of Clark’s academic descendants
will write a dissertation about it.
In fact, I anticipate that a lot of future
dissertations—probably from Clark’s academic home at the University of California,
Davis—will extend his insights and methods to other cultures, contexts, and data
sets. Clark-inspired investigations of the
former Soviet Union and African countries, for example, would be extremely useful complements to this book. And some
interesting debate about the minutiae of
his data and methods will find homes on
the specialized pages of journals like the
Journal of Economic History, Economic History
Review, and European Review of Economic
History (which Clark edits).
Finance According to
Non-Academics
✒ Review by Vern McKinley
O
ver the past year, my reviews in Regulation have concentrated
on books by academics expounding their views on the causes
of and responses to the 2007–2008 financial crisis. This time,
I’m reviewing three books on the crisis and other financial policy issues
that have been written by non-academics: Nomi Prins, a journalist
and former Wall Street analyst currently
affiliated with Demos, a progressive public policy group; Steve Forbes, chairman
and editor-in-chief of Forbes Media, and
co-author Elizabeth Ames, a communications executive, speaker, and author; and
Michael Lewis, a former Salomon Brothers bond salesman and best-selling author
of the books Liar’s Poker (W. W. Norton,
1989), Moneyball (W. W. Norton, 2003),
and The Big Short (W. W. Norton, 2010).
V er n McKinley is a visiting scholar at the George
Washington University Law School and author of Financing
Failure: A Century of Bailouts (Independent Institute: 2012).
Presidents and bankers / There is much
to be said for Prins’ book, All the Presidents’ Bankers. It is a well researched and
annotated history of the interconnections between U.S. presidents and private
bankers from the days of President Teddy
Roosevelt and the Panic of 1907 through
President Obama and the Great Recession of 2007–2009. The book’s endnotes
reveal a painstaking journey through a
wide range of contemporary books, articles, and original documents drawn from
the deep bowels of the archives of numerous presidents.
Spring 2015
Much of the book
and events, domestic or foreign,
focuses on the “Big
where the strongest associations
Six,” a group of leadwere apparent over time. (McCloy
ers of the largest banks
is a perfect example of this.) This
that first came together
is probably not how I would have
in 1929 with represenapproached this history, as I would
tatives from Chase
have tended to focus more on key
National Bank, Bankers
domestic banking events and the
Trust Company, Guarbankers’ influence upon them, but
anty Trust Company,
such decisions are the prerogative
National City Bank,
of the author.
Morgan Bank, and First
One reason I would have focused
National Bank. Prins All the Presidents’
on key domestic banking events
very ably traces the Bankers: The Hidden
would be to give more attention
evolution of this group Alliances That Drive
to important financial events of
American Power
over time all the way
the past century that Prins largely
through the megamerg- By Nomi Prins
ignores or treats only superficially.
ers of the 1990s and 521 pp.; Nation Books, For instance, in her book the War
the financial crisis of 2014
Finance Corporation—a bank bailthe 2000s into today’s
out program during World War I—
“permutations of the
only rates a very brief reference to
original Big Six”: J.P. Morgan Chase, Mor- its chairman, Eugene Meyer. The saga of
gan Stanley, Citigroup, Goldman Sachs, Continental Illinois and its near collapse
Bank of America, and Wells Fargo.
and rescue by the federal government durPrins chose to undertake an unbroken ing the mid-1980s does not even get a menhistory of modern U.S. banking. The upside tion. And Fannie Mae and Freddie Mac are
of this approach is that, with a few excep- only briefly discussed as part of the string
tions, there is a feeling of completeness to of bailouts in 2008–2009.
the work spanning over 100 years. HowIn some cases the analysis of the book
ever, to me a downside of this approach is appears to be based on innuendo rather
that some of the narratives are far afield than fact. For example, during the Panic
from matters of banking, finance, and the of 1907 a number of significant financial
financial industry. For example, the author institutions were on the brink of failure
chronicles a range of foreign policy issues, after experiencing a run on their deposits.
oftentimes simply because a key banker is Ultimately, the authorities facing tough
involved in them in some official or unoffi- choices on New York institutions closed
cial capacity. An example of this is a section down Knickerbocker Trust while other
on the Shah of Iran seeking political asylum institutions such as Trust Company of
in the United States, which was included America were bailed out by a consorbecause it involved bankers John McCloy tium of banks. One history of the crisis
and John Rockefeller.
explains that these decisions were based
This approach made me curious about on a detailed review of the financial posiwhat methodology Prins used to choose tion of the firms, overseen by J.P. Morgan
the hundreds of topics that she covers in and undertaken by Benjamin Strong (who
the book. She explained to me that the would later become the first president of
process started with each of the presi- the powerful Federal Reserve Bank of New
dents and key administration figures and York). Strong’s analysis determined that
worked outward to the individual bankers Knickerbocker was insolvent; Trust Comwhose names appeared in the presidential pany of America was solvent and worthy
archives. Because this search led to an enor- of backstopping. (For more on this, see
mous amount of material, the analysis was Robert Bruner and Sean Carr’s The Panic
then narrowed down to those individuals of 1907 [Wiley, 2007].) Prins implies that
/ Regulation / 49
the Trust Company of America decision
was not based on an objective analysis
of solvency, but rather that the firm was
saved because it had “more substantive
ties to the major banks” and “had been
blessed by the sponsorship of the Morgan
team.” In contrast, Knickerbocker “had
not garnered similar banker support.” The
precise meaning of those phrases, as well as
any underlying analysis, is not well documented by Prins.
In other cases, she makes very clear
her views of the lucrative nature of the
connections between bankers and their
presidents:
During the postwar phase of the 1940s,
[Winthrop] Aldrich traveled the world
in a triple capacity: as chairman of the
Chase Bank, president of the International Chamber of Commerce, and
chairman of the Committee for Financing Foreign Trade. The impact on the
bank’s bottom line was substantial….
The volume of business handled in all
divisions of the foreign department
increased enormously. Chase commercial loans in London doubled that year.
Aldrich’s dual work as public servant
and private banker was reaping rewards
for his firm, and for his status as a diplomat. His partnership with [President
Harry] Truman assured him of both.
Like many progressives, Prins repeatedly stresses the deregulation bogeyman at
numerous points throughout the 1980s,
1990s, and 2000s under presidents Jimmy
Carter, Ronald Reagan, George H. W. Bush,
and Bill Clinton, and blames this phenomenon for the “meltdown” of 2007–2008. Yet
she offers little consideration or scrutiny
of the bubble-inducing housing and loosemoney policies in the lead-up to the crisis.
The detail on the 2007–2009 recession
and financial crisis is not very deep. In a
mere 4.5 pages, Prins addresses the full
range of bank bailouts, from Bear Stearns
in March 2008 through TARP and the bailout of Bank of America in early 2009. In her
preface, she cites the information challenges
of modern times and that the relationships
50 / Regulation / Spring 2015
in review
between George W. Bush and
but we have a pitiful and fragBarack Obama and the leadile recovery as evidenced by
ing bankers of today are just
feeble growth, misallocation
not as readily available because
of credit through government
of the nature of modern compolicies, skyrocketing debt,
munications. (“Bankers don’t
and ongoing economic and
put much in writing anymore,
financial volatility.
and there have been no tapes
Forbes and Ames lay much
of White House conversations
of the blame for this state of
since Nixon.”) She also notes
affairs on unstable money:
that a number of Freedom
Unstable money is a little bit
of Information Act requests
like carbon monoxide. It’s
at the Reagan, George H. W. Money: How the
odorless and colorless. Most
Bush, and Clinton libraries Destruction of the
Dollar Threatens the
were not responded to in time Global Economy—and people don’t realize the damage it’s doing until it’s very
for the release of the book. As What We Can Do
nearly too late. A fundamental
someone who has filed many about It
principle is that when money
FOIA suits to undertake my By Steve Forbes and
is weakened, people seek
own writing projects, I can Elizabeth Ames
250
pp.;
McGraw-Hill,
to preserve their wealth by
bear witness to these facts
investing in commodities and
on information availability. I 2014
hard assets. Prices of things
would add that the Obama
like housing, food, and fuel
administration, which had
start to rise, and we are often slow to
vowed to be the “most transparent adminrealize what’s happening.
istration in history,” is not really very transparent after all and its immediate predecesThe authors offer detail in rapid-fire
sors would also not be in the running for
succession on a number of diverse topics
that honor.
If you are drawn to the concept of a at the core of our financial and monetary
century-long walk through the relation- system:
ships between U.S. presidents and bankers,
■■ A detailed look at money and its three
I think you would enjoy All the Presidents’
roles: measure of value, instrument of
Bankers. If you are looking for a history
trust that permits transactions, and
of those events with extended analysis of
a system of communication. Most of
the policy-based decisionmaking process,
this is basic Economics 101 and can be
I think you would be disappointed.
skimmed by most readers.
Glory of gold / Money: How the Destruction of
■■ Money and trade: The authors assess
the Dollar Threatens the Global Economy—and
the distortive approach that many ecoWhat We Can Do about It is predominantly
nomic analysts take in addressing this
a blend of history and economic policy
topic by focusing solely on the level of
analysis on the state of money, which
the merchandise trade deficit. Again,
includes a detailed analysis of a proposed
this is basic Economics 101, updated
gold standard for the 21st century. Near
for many of today’s monetary and
the end, it morphs into a personal finance
financial events.
■■ Why inflation is not a good thing:
book à la Suze Orman, diving down into
addresses the phenomenon of quandetail on what the discussion of money
titative easing (“The biggest monetary
means for investors on an individual basis.
stimulus ever had produced the weakThe initial chapter of Money is an exploest recovery from a major downturn in
ration of our current state of affairs with
American history”) and the question
regard to the economy: we may be over
of why there has not been more inflathe so-called “Great Recession” for now,
tion, notwithstanding all of the monetary easing. The authors’ answers to
these questions focus on weakness in
the methodology for the calculation
of inflation; recent increases in the
prices of commodities, in particular
gold; and the fact that we are now in
“uncharted territory” with regard to
quantitative easing. The last point is
the most important, as the jury is still
out on the risk of inflation. Forbes and
Ames properly focus on the economy in
2000 and the recession that began in
2001 as an inflection point for the monetary strategy that has so greatly contributed to the churning and volatility
in the economy for the past 14 years of
uncertainty. They end this chapter with
the right question, “Should the Federal
Reserve really be in the business of finetuning the economy?”
■■ Money and morality: chronicles the
social unrest and instability that historically flows from debasement of
currencies. Forbes and Ames note the
oft-told story of the German Weimar
Republic and draw from John Locke
to support their contention that “the
debasement of money drives a fissure
into the core of society by defrauding
both lender and borrower.” They then
bring the moral issues to the most
recent financial crisis, citing the social
unrest in countries throughout Europe,
tensions in the Middle East during the
Arab Spring protests, the Occupy Wall
Street movement in the United States,
the expansion of government corruption, and the breakdown in what they
call “trust assurance mechanisms” like
credit review procedures and bond
credit ratings. The authors complete
this chapter on an ominous note by
returning to a historical example:
By 476 A.D., when barbarians wiped
the empire from the map, Rome had
committed moral and economic suicide. Romans first lost their character.
Then, as a consequence, they lost their
liberties and ultimately their civilization. Will that be us?
Spring 2015
For those who regularly follow the economic and financial industry (through the
Wall Street Journal, Bloomberg, CNBC, etc.),
most of this early analysis will be familiar
and not particularly earth-shattering. But
it represents a good review in preparation
for the core of the book, which is the argument for a 21st century gold standard:
We need gold because, as we’ve emphasized throughout this book, gold is the
best and the only way to achieve truly
stable money. Relinking the dollar to
gold would eliminate the economic
volatility and monetary crises that have
been the consequences of fiat money.
It would stop the erosion of our wealth
that is taking place today as a result of
Fed-engineered inflation. With a gold
standard, there would be no inflation.
The authors then summarize their
ideas for a gold standard in list format,
addressing in turn: four options for the
gold standard, the recommended features
for a gold standard for the 21st century,
and some myths and misconceptions
about the gold standard. The last section
is probably the most useful as it counters
gold standard critics by addressing one-byone many of the common criticisms of the
gold standard: the extent of price volatility for gold, limitations on the supply of
gold to sustain a gold standard today, the
gold standard being among the causes and
prolongation of the Great Depression, and
the ability of speculators to undermine a
gold standard.
I should note that some of the authors’
responses to those concerns are not completely satisfying. For example, they lay
the blame for the Great Depression on
the Smoot-Hawley Tariff Act, which is a
tremendous oversimplification.
The most convincing of their arguments
for a gold standard relates to politics:
Gold takes decisions about the value
and supply of money out of the hands
of bureaucrats whose judgment is too
often in error or driven by politics….
A gold standard puts the lid on the
shenanigans politicians like to use for
/ Regulation / 51
algorithms to trade securities and, according to Lewis, “front-run” the trades of others—this is where traders are tipped off to
the demand for a stock on one exchange
and buy it at a lower price on another and
arbitrage. Those who follow this strategy
A few final comments on the overall style make mere pennies per trade, but cumuof Forbes and Ames are in order at this point. latively make massive profits in essentially
It is hard to measure with any
risk-free trades. Lewis argues
type of metric, but the authors
through his storytelling that
rely on the opinions of others
because of HFTs, the market
a great deal, quoting them at
is “rigged” and is essentially
length and to what seems an
a “fraud.” He puts the story
outsized extent. As a reader
in an “us against them” conI generally expect authors to
struct, where “ordinary invespredominantly present their
tors” are getting screwed by
own interpretations and opinthe HFTs. This is ominously
ions on the topic at hand.
stated on the book jacket,
Additionally, the topic of
which warns “if you have any
money itself can be dense.
contact with the market, even
Presenting the material in a Flash Boys: A Wall
a retirement account, this
variety of formats—not only Street Revolt
story is happening to you.”
with words but also with By Michael Lewis
According to Lewis, HFTs
tables and graphs blended 274 pp.; W. W. Norton, dominate the market, not
in—is ideal. Economist Alan 2014
because they are doing a betBlinder effectively uses graphs
ter job of delivering their serand tables, although I do not
vices like true capitalists, but
agree with him on policy. However, Forbes because of the convoluted business model
and Ames almost exclusively describe mat- and technological basis for HFTs’ tradters of money through words. In fact, I ing. That supposedly gives an advantage
could find only one graph and not a single to those firms who figure out how to cut
table in their book.
milliseconds off trading times through
time-staking placement of servers and fiber
Tales of HFTs / Flash Boys: A Wall Street Revolt
optic cable wires. As Lewis summarizes it:
is another in a series of Michael Lewis’s
The U.S. stock market was now a class
trademark genre of financial journalsystem, rooted in speed, of haves and
ism. Like his classic book The Big Short, he
have-nots. The haves paid for nanosecabsorbs himself in a topic by interviewing
onds; the have-nots had no idea that
a myriad of people working in the industry
a nanosecond had value. The haves
segment under scrutiny and then weaves a
enjoyed a perfect view of the market; the
narrative of the most interesting characters
have-nots never saw the market at all.
into an entertaining, humorous, gripping,
The heroes in Lewis’s one-sided saga
and profanity-sprinkled read. It should be
noted that Lewis’s stories are not heavy on are a motley crew of characters who work
financial sector policy; in fact, I purchased on putting together a platform to counterand began reading The Big Short back in act the convoluted strategies of the HFTs
2010 when I was writing my own book on through a competing stock exchange:
the financial crisis, but abandoned Lewis’s
■■ Brad Katsuyama, the book’s lead charbook less than halfway through.
acter and a former trader for Royal
His new book places the strategy of
Bank of Canada (RBC), who after years
“high frequency traders” (HFTs) in the
of working in the market had an epiphworst of lights. HFTs are traders who use
political gain. We’ve all seen the effects
of leaving monetary and fiscal discretion in the hands of politicians and
their appointees: chronic inflation and
chronic government debt.
52 / Regulation / Spring 2015
in review
any regarding the inherent unfairness
in the market:
That’s when I realized the markets are
rigged. And I knew it had to do with
the technology. That the answer lay
beneath the surface of the technology. I
had absolutely no idea where. But that’s
when the lightbulb went off that the
only way I’m going to find out what’s
going on is if I go beneath the surface.
He later led the creation of the IEX in
2012, an exchange that is now competing head-to-head with the other
exchanges tainted by HFTs, by leveraging its distinct business model.
■■
■■
Rob Park, a former co-worker of Katsuyama’s when they developed RBC’s
trading algorithm. He was hired by Katsuyama to help him investigate what
was “beneath the surface.”
Ronan Ryan, an Irish immigrant, who
stayed behind in the United States after
his dad returned to Ireland following a
work stint here. A self-described “tech
guy” who always had a desire to work
on Wall Street, he joined Katsuyama’s
cause because of his knowledge of “the
frantic competition for nanoseconds.”
An additional featured character not
connected with Katsuyama is Sergey
Aleynikov, a Russian computer programmer who immigrated to the United States
and ultimately worked at Goldman Sachs,
patching up their old trading platform.
He departed Goldman to work for a new
hedge fund in order to develop an entirely
new trading platform. He was later arrested
by the Federal Bureau of Investigation and
charged by the government with stealing
code from Goldman Sachs. Lewis explains
his focus on Aleynikov
I’d thought it strange, after the financial
crisis, in which Goldman had played
such an important role, that the only
Goldman Sachs employee who had been
charged with any sort of crime was the
employee who had taken something
from Goldman Sachs.
Lewis does not directly delve into the policy implications for HFTs, but it is clear from
his narrative that he thinks something needs
to be done about them. Throughout the
book he takes shots at HFTs on a number of
fronts: the two-tiered system that they reveal,
the role of HFTs in causing so-called “flash
crashes” where there is a dramatic drop in the
stock price of a single firm or the market as a
whole, and their role in undermining market
integrity. Despite his complaints, I find Lewis
less convincing than Holly Bell’s July 2013
Cato Policy Analysis (“High Frequency Trading:
Do Regulators Need to Control this Tool of
Informationally Efficient Markets?” #731)
argument that HFTs in general are not bad
things and they cannot be blamed for Lewis’s
list of market ills.
Not surprisingly, Lewis’s book has
caused a divide on Wall Street. The
response of William O’Brien, president
of BATS Global Markets, in a debate with
Lewis and Katsuyama is typical (“The
Great HFT Debate with Michael Lewis on
CNBC,” available on YouTube): “The first
thing I’d say is, Michael and Brad, shame
on both of you for falsely accusing literally
thousands of people and possibly scaring
millions of investors in an effort to promote a business model.”
But Katsuyama gets it right when he
responds that the “market [is] providing
the solution,” as demonstrated by his IEX.
If HFTs really are a problem, IEX will prosper and be copied; if not, it will fade away.
For me, the policy divide over HFTs is
much ado about nothing. As a small, individual investor, I don’t feel like I have been
cheated by the HFTs, as I am in the market
for the long run. The best way to look at
Flash Boys is that it is an entertaining read—
but not an important policy analysis.
Adam Smith’s Guide to Living
✒ Review by David R. Henderson
T
he great 18th century economist and moral philosopher Adam
Smith published two major treatises during his lifetime. The
better-known Wealth of Nations (WN), published in 1776, is
one of the first landmark economics books and some claim that it
was the start of political economy. In it, Smith argues that for the
well-being of the vast majority of people to
improve steadily, the government must play
a limited role: providing defense and protection, building some infrastructure, and not
much else. He also argues that economic
freedom harnesses self-interest, so that by
doing well for ourselves, within the bounds
of justice, we do good for our fellow man.
His earlier book, The Theory of Moral
Sentiments (TMS), published in 1759, is different. In it, he discusses how we should
behave toward each other. He puts much
less weight on self-interest and highlights
beneficence toward our fellow humans.
Dav id R . Hender son is a research fellow with the
Hoover Institution and an associate professor of economics
at the Graduate School of Business and Public Policy at the
Naval Postgraduate School in Monterey, Calif. He is the
editor of The Concise Encyclopedia of Economics (Liberty Fund,
2008). He blogs at www.econlog.econlib.org.
Did the 17 years between the books
cause him to become less optimistic about
the fundamental nature of human beings?
One might think so. But in How Adam Smith
Can Change Your Life, economist Russ Roberts makes a persuasive case that Smith did
not change at all, but was merely addressing two different questions. In WN, Smith
explains that an increasingly extensive division of labor, which causes us to depend
more and more on the actions of strangers who are more and more distant from
us, makes us better off. The self-interest of
these strangers causes them to work for us
even if they never hear of us. According to
Roberts, TMS by contrast “is overwhelmingly a book about the people closest to us,
the ones we can actively sympathize with—
Spring 2015
our family, our friends, and our immediate neighbors.” George Mason University
economist Daniel Klein, whom Roberts
references, believes TMS is about political
ethics as well as private morals. Nevertheless, they both agree, as did the late Ronald
Coase, there is no contradiction between
WN and TMS.
Roberts’ goal, at which he succeeds
admirably, is to elaborate
on Smith’s insights in TMS,
explaining many passages
from the 1759 book and making the insights vivid through
contemporary examples from
his own life and the modern
world. Toward the end, Roberts shows that even in TMS,
Smith had some things to say
about how intrusive governments can cause problems.
elements. The first is to observe propriety.
This means, according to Roberts, meeting
the expectations of those around us: acting in the way they expect, which makes it
easier for them to interact with us. Roberts
gives many examples, ranging from saying
“please” and “thank you” to sympathizing
with people in their moments of grief.
But what if people’s expectations of us
are improper? Roberts doesn’t
raise this question explicitly,
but he addresses it using
Smith’s conception of virtue.
Virtue, for Smith, involves
prudence, justice, and beneficence. In modern terms, writes
Roberts, prudence means
“taking care of yourself”; justice means “not hurting others”; and beneficence means
“being good to others.”
The prudent man, claims
How Adam Smith
Being lovely / Roberts does
Roberts, does not smoke, is
Can Change Your Life
a marvelous job of explain“physically active and keeps
By Russ Roberts
ing Smith’s insights about
his weight under control,”
humans. Nine of the 10 chap- 251 pp.; Portfolio/
and “works hard and avoids
Penguin, 2014
ters are on particular themes
debt.” On debt, I must part
in Smith’s book, including
company. It was by taking on
how to know yourself, how
what seemed like a massive
to be happy, how not to fool yourself, how debt at the time—1986—that my wife and
to be loved, and how to be lovely.
I managed to buy a house in coastal CaliIn one chapter, Roberts introduces his fornia. I doubt that Roberts would have
own law, “The Iron Law of You.” It states criticized our decision even prospectively.
that you care more about yourself than you So I think he must mean something like
do about others and that others care more “avoids too much debt” or “consistently
about themselves than they do about you. spends beyond his means.”
We can offset this, Roberts writes, by payBeing just is relatively easy to undering attention to the person whom Smith stand: don’t cheat. It’s important, note
called “the impartial spectator.” Who is both Roberts and Smith, not to cheat in
this spectator? God? No. Roberts writes even little ways. If we do, there will be,
that it’s a kind of human being looking writes Smith, “no enormity so gross of
over our shoulder, one who thinks beyond which we may not be capable.”
us and our narrow concerns.
Beneficence is harder to define. AccordHow do we become happy? Smith ing to Smith, the rules of beneficence are
wrote, “Man naturally desires, not only “loose, vague, and indeterminate.” Robto be loved, but to be lovely.” If we figure erts writes that some of its aspects are
those two things out, we will be happy. “friendship, humanity, hospitality [and]
And by being lovely, Smith meant being generosity.”
worthy of being loved. If we strive to be
He discusses his challenges in following
lovely, Roberts writes, then we will be loved. these rules while raising four children. One
That raises the question, how do we beneficent rule he created was always to take
become lovely? There are two important his daughter’s or son’s hand when offered. A
/ Regulation / 53
rule I created for myself before my daughter
was a year old was, when she asked me to
play with her or do anything with her, to say
yes at least 90 percent of the time.
Good and bad systems / The two chapters
most directly relevant to readers of this
magazine are “How to Make the World a
Better Place” and “How Not to Make the
World a Better Place.” In the former chapter, Roberts discusses a range of phenomena, from the evolution of language, to
men wearing hats, to traffic patterns—all
of which Adam Ferguson, a Scottish contemporary of Smith, called “the result of
human action, but not of human design.”
In Roberts’ view, thinking “clearly about
the complex interaction of individual
actions that lead to unintended patterns
of predictable and orderly outcomes” is “the
single deepest contribution of economics
to understanding how the world works.”
Roberts notes the irony that Smith’s most
profound thoughts on the ways in which we
benefit others without particularly intending to do so are found more in TMS than in
WN. The bottom line here is that to make
the world a better place, we need to be good
people. We are not likely, on our own, to
make the bigger world much better, but we
should do our share.
To take an example from my own life, I
don’t believe that the few hundred dollars
I give to each of four or five charities every
year will have a noticeable effect on the
world. And yet I do give because I feel an
obligation to give to charities that do good.
As Roberts writes, “When you behave with
virtue, you are helping to sustain” a system
of norms and informal rules.
In “How Not to Make the World a Better Place,” Roberts highlights Smith’s criticism of what he called “the man of system”
and what I call “the life arranger.” Smith
writes that the man of system
seems to imagine that he can arrange
the different members of a great society
with as much ease as the hand arranges
the different pieces upon a chess-board.
He does not consider that the pieces
upon the chess-board have no other
54 / Regulation / Spring 2015
in review
principle of motion besides that which
the hand impresses upon them; but
that, in the great chess-board of human
society, every single piece has a principle of motion of its own, altogether
different from that which the legislature
might chuse to impress upon it. If those
two principles coincide and act in the
same direction, the game of human
society will go on easily and harmoniously, and is very likely to be happy and
successful. If they are opposite or different, the game will go on miserably, and
the society must be at all times in the
highest degree of disorder.
Roberts gives examples of “men of system,” ranging from extreme mass murderers—Pol Pot, Stalin, and Mao (I would
have added Hitler)—to the less extreme
examples we see in the United States: those
who decided to invade and try to remake
Iraq and those who think the government
can achieve good results with the drug war.
Roberts writes that people often “have
trouble remembering that there are other
ways of changing the world than using legislation.” He takes the example of smoking.
Per-capita consumption of tobacco in the
United States “fell by 50 percent in the last
half of the twentieth century.” Admittedly,
some of this was due to higher taxes on cigarettes and restrictions on where one can
smoke. But most of those restrictions came
along within the past 20 years, by which time
much of the decline had already occurred.
Roberts writes, “Smoking is no longer cool
or hip.” Great change happened because
individual people decided to change.
Men of system, take note. And get lost.
From More than Zero
to Less than One
✒ Review by Pierre Lemieux
P
eter Thiel co-founded PayPal in 1998. The intention was “to create a new internet currency to replace the U.S. dollar … [with] a
digital currency that would be controlled by individuals instead
of governments.” After selling the company to eBay, he became a very
successful venture capitalist, including being the first outside investor
in Facebook. Another startup in which he
has invested is SpaceX, the private space
flight company whose reusable rockets
are “the key to making human life multiplanetary,” according to the company’s
website. He is now a billionaire.
Thiel is also an avowed libertarian. He
expounded his version of libertarianism in
“The Education of a Libertarian,” published
in the April 2009 Cato Unbound. Unlike most
Silicon Valley entrepreneurs, his political
contributions go to Libertarian and Republican candidates. He has financially backed
the Seasteading Institute, which aims to
Pier r e Lemieux is an economist affiliated with the
Department of Management Sciences at the Université du
Québec en Outaouais. His latest book is Who Needs Jobs?
(Palgrave Macmillan, 2014).
create autonomous communities on manbuilt structures at sea.
Now he has published Zero to One, a
book in which he offers insights into business innovation and economic growth. It
is more than the typical billionaire’s ghostwritten book: it is based on the notes taken
by a student—Blake Masters, the book’s
co-author—in a class Thiel gave at Stanford
University in 2012.
In the book, Thiel explains how successful startups—those that change the world—
are created and managed. He argues that
they are monopolies and that, in terms of
economic growth, monopolies are preferable to market competition because successful monopolies typically create completely
new goods. Instead of merely “adding more
to something familiar,” of going from one
to some finite number on an allegorical
scale of innovation, they go from zero to
one, approaching infinite growth.
/ Business
management theory is a very soft field,
often based on slogans and fads. Looking over the past decades, think of such
management-techniques-cum-mantras
as “management by objectives,” “the pursuit of excellence,” “employee empowerment,” “business process engineering,”
“core competencies,” and “six sigma,” not
to mention the Japanese model, business
ethics, “corporate social responsibility,”
and corporate governance.
Thiel should not be held to standards
that full-time management gurus do not
reach. Moreover, he is more interested in
entrepreneurship and the creation of new
businesses than in dry management of
established dinosaurs. The entrepreneurship he practices and preaches resembles
the Kirznerian type (after Austrian School
economic theorist Israel Kirzner), defined
as the mysterious alertness and ability to
see opportunities that nobody else notices.
You need to “have secrets,” writes Thiel—
that is, “specific reasons for success that
other people don’t see.”
It follows that entrepreneurship is not
teachable: “The paradox of teaching entrepreneurship is that such a formula necessarily cannot exist.” It is no surprise then
that Zero to One has problems explaining it.
Thiel’s musings are often original.
For example, “a valuable business must
start by finding a niche and dominating
a small market.” Grand missions and big
plans are necessary. Founders should be
“unusual individuals” who “lead companies beyond mere incrementalism.” But
even if an entrepreneurial company should
mimic a cult, “you also need a structure to
keep everyone aligned for the long term.”
“A bad plan is better than no plan” (emphasis
in original).
The reader may find some of Theil’s
management principles a bit too obvious,
like “sales matter just as much as prod-
Entrepreneurial reflections
Spring 2015
ucts,” or “creating value is
that pay chosen students not
not enough—you also need to
to go to college. There may be
capture some of the value you
a contradiction here between
create.” But perhaps obvious
the espousal of populism and
things need to be repeated.
the implicit elitism of conYet Thiel yields to the
trarian entrepreneurs and
management guru’s tempthinkers, but Thiel does not
tation. He has seven quesexplore the issue.
tions that, if all answered
Competition and monopoly
positively, will ensure that
you “master fortune and
/ Thiel, whose formal training is in law, seems to hold
succeed.” His venture capital
economics in high suspicion.
fund claims to “never invest
Zero to One: Notes on
He gets many things right
in a tech CEO that wears a Startups, or How to
when he stays close to what
suit.” (Applicants for Thiel’s Build for the Future
he knows—when he defends
venture money take notice!) By Peter A. Thiel
the usefulness of technoIn a new venture, “working with Blake Masters
logical progress, for example.
remotely should be avoided.” 224 pp.; Crown
But economic analysis would
He postulates that “a startup Publishing, 2014
have saved him from some
messed up at its foundation
errors—or, at least, would
cannot be fixed.” Obscure
rhetoric is just around the corner: “no have helped him argue his case better.
Consider his take on competition,
company has a culture; every company is
monopoly, and capitalism. We can suma culture.”
Sometimes, he pushes his ideas too marize his argument in four points:
far and spreads them too thin. He seems
■■ Economics puts too much emphasis
to favor a very nonevolutionary vision of
on competition, “the ideal and the
progress: “How can the future get better if
default in Economics 101.”
no one plans for it?” He criticizes the use
■■ Monopoly, not competition, is the
of Darwinist evolution “to build a better
goal of business: “Monopoly is the condisociety,” apparently unaware of Hayek’s
tion of every successful business [emphasis
argument that Darwin borrowed the conin original]. … All failed companies
cept of evolution from social scientists, not
are the same: they failed to escape
the other way around.
competition.”
It is fashionable to criticize economists
■■ “Most businesses are much closer to
and they sometimes deserve it. Thiel falls
the extreme of monopoly than we
prey to a strand of libertarian thinking
commonly assume.”
that rejects rational choice. “In econom■■ “Capitalism and competition are
ics,” he argues, “disbelief in secrets leads
opposites.”
to faith in efficient markets.” He ignores
that markets tend to be efficient precisely These statements are either incomplete or
because intuitive and enthusiastic entre- incorrect, for the following reasons:
preneurs go against conventional wisdom, incorporate new information in Not all of economics overemphasizes compeprices, and push the market closer to its tition. Many economists, no doubt, have
mistakenly taken the explanatory model
equilibrium.
He also seems under the influence of of perfect competition as an exact ideal
another, sometimes parallel, strand of to be imposed onto real markets, as in
populist libertarianism that rejects the antitrust crusades. Yet, there is a positive
usefulness of formal, standardized learn- reason for sticking to competition as an
ing in favor of practical deeds and tradi- explanatory model: it often provides the
tional knowledge. He offers fellowships best model to describe what happens in
/ Regulation / 55
the real world, just as a Euclidian line
with zero thickness is useful to measure
real-world lines. At the normative level,
competition does have large benefits: the
tendency toward a competitive equilibrium allows consumers to get what they
want at the lowest possible price.
Perhaps it is true that monopoly “can
allow a business to transcend the daily
brute struggle for survival.” But a free
economy works for the benefits of consumers, not producers. Of this, the competitive
model serves as a constant reminder.
It is because businesses want monopolies that
competition exists. Thiel himself seems
to understand this: “The dynamism of
new monopolies itself explains why old
monopolies don’t strangle innovation.”
So why the criticism of competition?
When “monopolies” compete or face
potential competitors, we have a competitive system, not a monopolistic one.
There are no monopolies on a free market.
The problem with Thiel’s focus on monopolies might be a matter of definition. But
some definitions are more fruitful than
others. It is useful to view a monopoly as
a single firm protected from competition
by legal constraints to entry in its industry.
Thiel correctly opposes such constraints
and emphatically states that the good
monopolies he argues for are not the stateprotected variety. But then he tends to forget that there is no monopoly when many
firms compete, even if they are not equal.
There is a more fundamental argument
against seeing monopolies everywhere. As
Thiel himself suggests (without following
through on the idea), determining whether
there is competition or monopoly depends
on how one defines the relevant markets.
Google has 68 percent of the search-engine
market, which it uses for advertising, but
only 3.4 percent of the global advertising
market and only 0.24 percent of the consumer tech market (the figures are from
Thiel). How one defines a market is essentially arbitrary, so each firm can be thought
of as either a tiny monopoly or an atomistic competitor in the larger market. What
56 / Regulation / Spring 2015
in review
Thiel call “monopolies”—Google, Apple,
PayPal, etc.—are only large companies that
have dominant positions in some markets.
The opposition of capitalism and competition is not useful. One can define capitalism
and competition as one wants, including
in opposition to each other. But defining capitalism as an economic system
where there is no competition easily leads
to many errors. One is to forget the consumer in favor of the producer. Another
error is to underplay the importance of
freedom to enter markets and freedom
to compete—those freedoms being what
really matters if we are interested in economic efficiency and consumer welfare.
Poor economics / In his 1973 book Capital-
ism and the Permissive Society, Samuel Brittan expressed dismay at how inefficient
capitalists were at defending capitalism,
but noted that “businessmen are paid to
operate the system rather than understand or expound it.” I would add that
great entrepreneurs get their money for
the new opportunities they offer to consumers, but their economic and social
theories are not necessarily outstanding.
Zero to One does have the benefit of
emphasizing entrepreneurship, but one
would not use the book to teach either
political philosophy or economics. Consider the nature of value. Why does something have value? Thiel makes the strange
claim that Google creates less value than
the airlines. To reach that conclusion, he
equates a firm’s value with its revenues
or profits. A few centuries of economic
analysis teach that value is the “utility”
(satisfaction of preferences) that individuals get from exchange. If we use a partial
equilibrium framework, we can (conceptually) calculate value as the consumer
surplus—that is, the difference between
what consumers would have been willing
to pay for something and what they actually have to pay. Profits or rents translate
into value only because they allow their
recipients to get their own consumer
surpluses when they spend their money
as consumers. It is thus very likely that
Google creates much more value than
Thiel assumes.
To take another example, he compares
the revenues of venture capital–backed companies with gross domestic product, of which
the companies represent “an astounding 21
percent.” This is only astounding because
it compares revenues (total sales) of some
companies with value added (profits) in the
whole economy, GDP being the sum of the
latter, not of the former.
Zero to One is a small, easy-to-read book
in which the reader will learn about what a
great entrepreneur and libertarian visionary thinks. Some of this is interesting but
intellectually light. There is not a single
footnote in the book, so the reader cannot
check sources. On the positive side, Tyler
Cowen endorsed the book. But I suggest
that it will, at best, only take your social
and economic understanding from more
than zero to less than one.
Sunstein’s Knowledge
Problem
Review by Phil R. Murray
I
n the layman’s way of thinking, a regulation that saves just one life
is worthwhile regardless of its costs. In the economic way of thinking, a regulation that saves just one life is worthwhile only if it costs
less than the value of a life. Cass Sunstein expands on this economic
way of thinking in his new book, Valuing Life. In it, he documents his
experience overseeing the Office of Information and Regulatory Affairs (OIRA)
in the early years of the Obama administration, explains how the regulatory
apparatus works, and shares his views on
“humanizing” the process.
By “humanizing the regulatory state,”
Sunstein wants to accomplish four objectives. The first is to justify a widespread
application of cost-benefit analysis. He puts
it this way: cost-benefit analysis “should see
costs and benefits not as arithmetic abstractions, but as efforts to capture qualitatively
diverse goods and to promote sensible tradeoffs among them.” His second objective is to
recognize “nonquantifiable” factors such as
“dignity,” “equity,” and “privacy.” The third
is to incorporate behavioral economics into
cost-benefit analysis, and the fourth is “to
collect the dispersed information held by a
nation’s citizenry” and use that to formulate regulations.
OIRA’s work / Sunstein wants to remedy the
Phil R . Mur r ay is a professor of economics at Webber
International University.
“poorly understood” operation of OIRA,
which neither originates nor rubberstamps regulations. “It would not be excessive,” in his view, “to describe OIRA as, in
large part, an information aggregator.” By
gathering this “specialized information”
and “dispersed information,” he sees OIRA
trying to overcome the “knowledge problem” outlined by Friedrich Hayek.
OIRA aims “to promote a well-functioning process of public comment,
including state and local governments,
businesses large and small, and public
interest groups.” Sunstein describes this
as “regulatory due process.” There are four
essential aspects of OIRA procedure:
OIRA incorporates “interagency
views.”
■■ The discussion of these interagency
views explains why the OIRA procedure may be long and drawn out.
■■ Even though OIRA focuses on costs
and benefits, it concentrates more on
“interagency concerns, promoting
the receipt of public comments (for
■■
Spring 2015
/ What circumstances make a problem more challenging? Take a regulation that costs $200
million per year. The agency proposing it
estimates that it will save 24 people from
dying of cancer, and the VSL is $8 million. Although the benefits in this case
Valuing Life is not a manual with detailed in terms of lives saved ($192 million) are
instructions on how to calculate costs less than the costs, “it will be acceptable
and benefits. Sunstein presents dozens of for the agency to do a sensitivity analysis
“highly stylized problems” with the costs in which it increases the VSL because canand benefits given, and tells
cer is involved.” This is one
us how the process will coninstance in which Sunstein
tinue from there. The simadvocates “humanizing”
plest problem he presents is
regulations.
a regulation that costs $200
Consider his reasons
million per year and generfor humanizing regulaates $400 million in benefits
tions related to cancer. “For
per year. “In the process of
example,” he reports, “some
OIRA review, the numbers
evidence suggests that peowill be carefully scrutinized,
ple are willing to pay high
and many questions will be
amounts to avoid cancer
asked about their accuracy
risks, and hence there is reaand meaning,” he assures us,
son to think that people’s
Valuing Life: Human“but if those questions have izing the Regulatory
VSL is higher for cancer risks
good answers, this is an easy State
than sudden, unanticipated
one in favor of proceeding.” By Cass R. Sunstein
deaths.” Perhaps a greater
As part of that work, gov- 248 pp.; University of
aversion to death from canernment agencies estimate Chicago Press, 201
cer than, say, a heart attack
a “value of a statistical life
is rational. Sunstein adds
(VSL).” Sunstein explains:
that “all cancer fatalities are
“Suppose that workers must be paid $900, not the same; informed people would
on average, to assume a risk of 1:10,000. surely make distinctions between those
If so, the VSL would be said to be $9 mil- that involve long periods of suffering
lion.” For an alternative approach to reach and those that do not.” Despite people’s
the same VSL, suppose that one in 10,000 greater willingness to pay to avoid some
firefighters will die on the job and the risks over others, OIRA does not “distintypical firefighter is willing to pay $900 to guish among mortality risks” and never
eliminate that risk. Multiplying $900 per has. However, an agency may do “sensitivfirefighter by 10,000 firefighters yields $9 ity analysis,” add a “cancer premium” to
million, which is the value of eliminating the VSL, and possibly “conclude that the
the risk necessary to save one firefighter’s benefits ‘justify’ the costs.” That would
life. The simplest problem Sunstein pres- amount to the same thing as computing
ents that involves a life-saving regulation different VSLs based on different risks,
costs $300 million per year and saves 40 would it not?
lives. Using the $9 million VSL, the benSunstein is well known for using
efits of the regulation amount to $360 insights from behavioral economics to
million and “the regulation will likely go shape public policies. In Valuing Life, he
forward.” Note that if this regulation were describes a behavioral slip-up dubbed
to save just one life, it would be a mistake “probability neglect” that relates to canto implement it because the costs would cer risk. “People fall victim to probability
exceed the benefits.
neglect,” he explains, “if and to the extent
proposed rules), ensuring discussion
of alternatives, and promoting consideration of public comments (for final
rules).”
■■ OIRA’s work is “technical,” relating to
economics, science, the law, etc.
Humanizing regulation
/ Regulation / 57
that the intensity of their reaction does
not greatly vary even with large differences in the likelihood of harm.” Take the
results of an experiment Sunstein and a
colleague conducted with their law students. They queried a first group “to state
their maximum willingness to pay to eliminate a cancer risk of 1 in 1 million.” They
put the same question to another group
but increased the risk of cancer to one
in 100,000. A third group faced the same
question as the first, plus “the cancer was
described in vivid terms, as ‘very gruesome
and intensely painful, as the cancer eats
away at the internal organs of the body.’”
The fourth group faced the same question
as the second, along with the “emotional
description” of cancer.
If the subject of cancer causes people
to neglect probability, their willingness to pay to eliminate a risk of one in
100,000 will be less than 10 times that
for a risk of one in 1 million. That is what
Sunstein and his colleague found when
asking questions both with and without
the “emotional description” of cancer.
They also expected that adding the emotional description would cause greater
probability neglect, and confirmed that,
too. Subjects who heard the emotional
description stated a mean willingness
to pay of $211.67 to eliminate the one
in 1 million risk of cancer, compared
to $250 to eliminate the risk of one in
100,000. “When the cancer was described
in emotionally gripping terms,” in other
words, “people were insensitive to probability variations.”
This reviewer doubts that we should
attach much weight to a single experiment involving 67 students at Harvard
Law School. Nonetheless, Sunstein draws
from it “two implications for the public
reaction to emotionally gripping events.”
One is that “simply because such events
arouse strong feelings, they are likely to
trigger a larger behavioral response than
do statistically identical risks that do not
produce emotional reactions.” This is
the rationale an agency uses when considering a “cancer premium” along with
other benefits of a regulation designed to
58 / Regulation / Spring 2015
in review
reduce the risk of cancer. Another implication is “that probability neglect might
well play a role in the government’s reaction to emotionally gripping events, in
part because many people will focus on
the badness of the outcome, rather than
on its likelihood.”
This point raises the question of what
the government should do when events
such as terrorism raise the public’s alarm.
On the one hand, it would be wise to do
nothing. “There is a strong argument
that government should not respond,”
Sunstein reasons, “if the relevant risks
are very small and if the requested steps
have costs in excess of benefits.” There
is also a role for the government “to
inform and educate people” whenever
the probability of a tragic event is low.
“But if information and education do
not work,” Sunstein continues, “government might be willing to consider
regulatory responses to fears that are not
fully rational, but real and by hypothesis
difficult to eradicate.”
He is not using probability neglect as
an excuse to open the door wide for more
regulations. He warns that “a special difficulty here consists in the problem of
quantifying and monetizing fear and its
consequences.” Quantification and monetization are more ways of “humanizing”
regulations.
He presents a scenario in which the
costs of a regulation “to make buildings
more accessible to people who use wheelchairs” exceed the “monetized benefits.”
Officials proceed with the regulation,
nevertheless, by making a case that the
value of “human dignity” to wheelchair
users makes up for the deficiency of
monetized benefits. Sunstein cites the
actual reasoning of Justice Department
officials from a document pertaining
to the Americans with Disabilities Act:
“Dividing the $32.6 million annual cost
by the 677 million annual uses [of water
closets with doors that open outward,
making them more accessible], we conclude that for the costs and benefits to
break even in this context, people with
the relevant disabilities will have to value
safety, independence, and the avoidance
of stigma and humiliation at just under
5 cents per use.” It seems plausible that
this lower bound on the value of human
dignity would justify the costs of modifying such water closets. Sunstein recognizes “objections” to quantifying or
monetizing benefits, though he continues to advocate those practices.
Moral heuristics
/ I had suspected that
Sunstein was eager to regulate. In Valuing
Life, however, his presentation of behavioral economics causes me to reconsider.
“Heuristics” are “mental shortcuts” that
people use when making decisions. Even
though they may be reliable sometimes,
they may also produce bad outcomes. For
anyone who ever asked whether behavioral
economists ever cite the anomalies they are
so fond of to make a case against regulation,
Sunstein’s explanation of “moral heuristics” is evidence that he, for one, does.
Take the “Precautionary Principle,”
which according to Sunstein “is designed
to insert a ‘margin of safety’ into all decision making, and to impose a burden of
proof on proponents of activities or processes to establish that they are ‘safe.’”
(See “The Paralyzing Principle,” Winter
2002–2003.) That idea sounds reasonable
initially. But Sunstein deems it “incoherent.” “The reason,” he explains, “is that
risk regulation often introduces risks of
its own.”
His critique is so effective that this
reviewer wonders why the Precautionary Principle is not less popular. “For
example,” he continues, “regulation of
nuclear power might increase the likelihood that societies will depend on fossil
fuels, which create air pollution and emit
greenhouse gases.” The following point
not only goes against the Precautionary
Principle, but too much regulation in
general: “By its very nature, costly regulation threatens to increase unemployment
and poverty, and both of these increase
risks of mortality.”
Heuristics explain the principle’s intuitive appeal. One is the “act-omission distinction,” whereby regulators prohibit
endeavors with visible risks (such as the
Keystone XL pipeline) even though prohibition entails less visible risks (war over
oil in the Middle East). To be clear, Sunstein does not recognize moral heuristics
in order to reduce the number of pages
in the Federal Register. His goal is to refine
cost-benefit analysis. Whether his acolytes
show as much restraint when applying
behavioral economics to formulate regulations remains an open question.
Conclusion / Valuing Life contains no battle
stories involving regulators, politicians,
and lobbyists arguing over any regulation. There are a few glaring errors that
may be excused. Pertaining to “a regulation designed to reduce the incidence of
prison rape,” Sunstein writes, “If a single rape is valued at $500,000, the rule
would be easily justified if it prevented
only 1,600 rapes.” It is safe to assume
that he intended to write “if preventing a
single rape is valued at $500,000.” Likewise when he wrote “a dollar today is
worth less than a dollar tomorrow,” he
intended to write “a dollar today is worth
more than a dollar tomorrow.”
Readers might be surprised to learn
that OIRA listens to “businesses and others” who resist regulations on more occasions than it listens to “public interest
groups” who favor them. Sunstein claims
that OIRA avoids politics. “At least in my
experience (and some people will find
this surprising),” he admits, “‘politics,’
in the sense of interest-group pressures
and electoral considerations, usually does
not play a significant role in the regulatory process.”
Although he teaches that there may be
too much regulation as well as too little,
he maintains that “the financial crisis of
2008 and succeeding years was, in part, a
product of insufficient regulation, which
could have provided safeguards against
systemic risks.” Even the Financial Crisis
Inquiry Commission Report, which faults
free-market ideology for the crisis, also
blames regulatory forbearance. Sunstein
emphasizes his appreciation of Hayek.
“The Hayekian theme,” he explains,
Spring 2015
“emphasizes the dispersed nature of
human knowledge and OIRA’s role in
attempting to acquire as much of that
knowledge as possible, above all through
careful attention to public comments.” In
his conclusion he acknowledges that “it
is an understatement to say that [Hayek]
would not have endorsed all of the arguments in this book (much less all of the
regulations that the United States has
issued in the name of public health,
safety, and environmental protection).”
Given the knowledge problem, Sunstein
believes that OIRA’s role as “an information aggregator” is an appropriate way
to deal with it. One wonders whether
Hayek would endorse that approach or
judge it quixotic.
/ Regulation / 59
director’s cheat sheet, and that makes reading his portion of the book a chore for anyone who dislikes hackery. Fortunately, he
does ultimately circle back to discussing the
idea that data-driven government will make
“people’s lives better.”
Of course, Madden and Wolfson are
right in theory that both parties have
incentive to learn more about government programs and regulation in order
to drive better policy. The hurdle for applying Moneyball to government—as opposed
to just one or two instances that happen
to follow party dogma—is that statistical
analysis will sometimes indicate that a
strongly favored program is failing. Per✒ Review by Sam Batkins
haps politicians of both parties can accept
“Moneyballing” USAID, but what about
Social Security or defense appropriations?
eginning in the 1990s, Oakland Athletics general manager Billy
Rest assured, Madden, Wolfson, and
Beane gained acclaim for using statistical analysis to identify other book contributors are willing to critiundervalued players and baseball strategies, which he then used cize some government programs. But too
to turn the small-budget team into a consistent winner. Since then, all often their policy recommendations are
sorts of analysts have proposed applying similar “Moneyball” strate- for more government, such as establishgies to other human endeavors, including Howard Wolfson (a Democrat). They argue ing whole new offices for policy evaluagovernment.
that both sides of the aisle have incentive tion. There is a call for a “chief evaluation
Who could oppose collecting data to play Moneyball with government.
officer” in every federal agency, agencies
about government spending, building eviRepublicans presumably would benefit setting aside up to 1 percent of each agendence to implement effective programs, by pushing for more efficient government cy’s budget for evaluation, and the estaband directing funds away from failing poli- rather than being labeled “antigovern- lishment of “cross-government prizes for
cies? In the new book Moneyball for Govern- ment,” though that distinction may be innovative approaches to evaluation.” Supment, a plethora of writers, policy wonks, lost on some Republican politicians. For posedly, those actions would lead to agency
and two former heads of the federal Office Democrats, Wolfson proudly
innovation where before the
of Management and Budget make the case trumpets their strong record
agencies were content with
that a data-driven approach to government of fiscal responsibility. He
mediocrity. Whether the benand regulation would create better results points out that President
efits of the new measuring
at a lower cost to taxpayers.
Obama has recently been
devices are worth the costs is
Data and analytics about how govern- reducing the deficit at the
up for debate.
ment operates could certainly be improved. fastest rate since World War
From an agency perspecBut whatever the apparatus that policy- II—though he doesn’t say that
tive, the biggest obstacle to
makers establish to measure government, this reduction is from the
evaluation may be fear. In
self-interested politicians must still pay trillion-dollar deficits Obama
previous Moneyball initiaattention to the findings and be willing to rang up early in his presidency.
tives (and there have been
cut failing programs. Bill Niskanen noted If this represents the authors’
previous attempts), agencies
that in these pages many years ago (“More idea of an honest use of data
proved reluctant to change, in
Lonely Numbers,” Fall 2003), and I share then maybe we should forget Moneyball for
part because they feared that
Government
his skepticism about that possibility.
the Moneyball endeavor altosuccess would result in budBut that skepticism may be uncalled gether. Wolfson also spouts Edited by Jim Nussle
get cuts from appropriators.
and Peter Orszag
for, claim book contributors and political off standard attack lines on
The book devotes sig260 pp.; Disruption
advisers Kevin Madden (a Republican) and Republicans that sound like Books, 2014
nificant attention to the disthey were taken straight from
tinction between data and
Sa m Batk ins is director of regulatory studies at the
American Action Forum.
a Senate communications
evidence. There is plenty of
‘Moneyball for Government’
Needs ‘Moneyball’ Politicians
B
60 / Regulation / Spring 2015
in review
data on government programs, but as the
authors argue, little evidence that demonstrates what is working and what is failing.
Initial evidence, through a randomized
controlled trial, may reveal that a specific
regulation or program is not generating the
promised benefits. But even some of the
book’s contributors don’t seem willing to
heed such findings, as former agency heads
caution that the initial results of such analysis should not portend the end of a program.
That’s the problem with policymakers. Scores of analysts can point to failing or wasteful programs, but there will
always be a constituency or special interest prepared to defend each program, and
they have more at stake in that spending
battle than good-government advocates.
More data on evaluation will only create
a more efficient government if politicians
care enough about the data, and there is
plenty of evidence today that they do not.
There are several references to the Office
of Information and Regulatory Affairs
(OIRA) as a paragon for good data and
program evaluation. Any critical followers
of OIRA will question that praise. OIRA
reviews less than 10 percent of all federal
rules each year and while that review might
be extensive, political considerations from
OIRA’s White House overseers are common. What’s more, wide swaths of the
economy are exempt from its oversight:
Dodd-Frank, for instance, is virtually
exempt from OIRA review.
More faint praise for OIRA is inspired
by its “government-wide” retrospective
regulatory review that was done in 2011,
and is supposedly continuing today. First,
the review wasn’t government-wide, as it
wasn’t mandatory for independent agencies. And while the book’s authors may
claim that “the lookback process yielded
scores of measures to update regulatory
regimes,” the reality is decidedly different. As Ike Brannon and I have argued in
these pages (“First-Year Grades on Obama
Regulatory Reform,” Spring 2012), many
of those updates were in fact just new regulations implementing new programs rather
than an honest review of past regimes. Retrospective review has been successful at
increasing the nation’s regulatory tab, all
under the guise of “reform.”
There are dangers in embracing socalled Moneyball for government. New
hires designated for program evaluation could face resistance from agencies,
just as the Government Accountability
Office does currently. One percent budget set-asides for evaluation could evolve
into 1-percent add-ons, with few politicians willing to act on the recommendations. And it’s hard to see how regulatory
capture wouldn’t rear its ugly head sooner
rather than later in such an arrangement.
That’s not to say there aren’t good ideas
in this book. For one, interagency data sharing that allows the public to view which
programs are failing and which are the most
efficient will undoubtedly place additional
pressure on legislators. But to expect such
efforts to result in a government that functions as well as the private sector is optimistic. The federal government is unlikely
to function as efficiently as Beane’s A’s, but
performance akin to last season’s New York
Yankees is within reach.
Working Papers ✒ By Peter Van Doren
A summary of recent papers that may be of interest to Regulation’s readers.
SEC Regulation
“Corporate Governance and the Creation of the SEC,” by Arevik
Avedian, Henrik Cronqvist, and Marc Weidenmier. September 2014.
SSRN #2498007.
“The Costs and Benefits of Mandatory Securities Regulation:
Evidence from Market Reactions to the JOBS Act of 2012,” by Dhammika Dharmapala and Vikramaditya S. Khanna. July 2014. SSRN
#2293167.
D
oes regulation of stocks and bonds by the Securities and
Exchange Commission, with its regime of registration
and mandated information provision, create net benefits
for investors? In these pages, Michael Greenstone, Paul Oyer,
and Annette Vissing-Jørgensen argued in the affirmative (“The
Value of Knowing,” Summer 2006). They analyzed the effects of
Peter Va n Dor en is editor of Regulation and a senior fellow at the Cato Institute.
the Securities Acts Amendments of 1964, which extended the
registration and disclosure regime to stocks traded “over the
counter,” and found positive abnormal returns of $3–$6 billion.
On the other hand, in these same pages Elizabeth de Fontenay
compared corporate bonds subject to disclosure requirements
with syndicated loans, which are not subject to such requirements (“Putting Securities Laws to the Test,” Fall 2014). She
found the syndicated loan market to be thriving and growing,
suggesting that investors found little value from the registration
information requirements.
Now, two new working papers take up this question. The first,
by Arevik Avedian, Henrik Cronqvist, and Marc Weidenmier,
analyzes the effect of SEC regulation by comparing stocks listed
on the New York Stock Exchange (NYSE) with stocks listed on
the regional exchanges. The main effect of the 1933 Securities Act
was to take NYSE listing standards at that time, convert them into
federal law, and apply them to publicly traded firms on regional
exchanges. The authors conduct a difference-in-differences analysis of NYSE and non-NYSE firms before and after the act’s cre-
Spring 2015
ation of the SEC. Their measure is whether a majority of board
members are “independent,” meaning they are neither officers
nor family members of officers. The authors find a 30 percent
reduction in board independence of the regional firms post-SEC,
but no change in firm valuation by investors. Firms traded off
private and public provision of reassurance. As government supply increased, the private supply of reassurance through board
independence was reduced.
The second paper, by Dhammika Dharmapala and Vikramaditya Khanna, examines the effects of the JOBS (Jumpstart Our
Business Startups) Act of 2012. The law relaxed disclosure and
compliance rules for “emerging growth companies” (primarily
those firms with less than $1 billion in revenue)—whose initial
public offering (IPO) of stock was after December 8, 2011. The
authors conducted an event study comparing small firms with
IPOs between July 2011 and December 8, 2011 to small firms with
IPOs between December 9, 2011 and April 5, 2012, when President
Obama signed the bill into law. Some 87 firms conducted IPOs
between July 2011 and April 5, 2012. The control group contains
33 firms with less than $1 billion in revenue whose IPO was prior
to December 8, 2011.
The authors calculate whether differences in returns between
treatment and control firms (so-called cumulative abnormal
returns) exist in the event window (February 29 to April 9,
2012) surrounding a prominent March 15 statement by Senate
Majority Leader Harry Reid’s (D–Nev.) about the importance of
the bill. The event window starts with House Financial Services
Committee’s approval of the bill, which included an explicit
relaxation of the rules for all IPOs after Dec. 8, 2011, and ends
four days after the presidential signing on April 5, 2012. The
central result is positive abnormal returns of 3–4 percent for
treatment relative to control firms during the event window.
Investors reacted as if elimination of the SEC reporting requirements for small firms created net benefits that were reflected in
positive abnormal returns. Cash Transfers and
Educational Attainment
“Human Capital Effects of Anti-Poverty Programs: Evidence from a
Randomized Housing Voucher Lottery,” by Brian Jacob, Max Kapustin, and Jens Ludwig. May 2014. NBER #20164.
W
hy do poor parents have children who also grow up
to be poor? One possible explanation is that poor
families do not have access to credit that would allow
parents to invest more in the human capital improvement of
their children. The policy solution that results from this notion
is to increase transfers to poor families in order to remove their
credit constraints.
The expansion of the Earned Income Tax Credit (EITC)—which
uses the tax system to transfer money to low-income households—
/ Regulation / 61
has been shown to increase standardized test scores. But critics
argue that factors unobservable to researchers but correlated
with EITC receipt are responsible for children’s success, not the
EITC transfers.
In this study, Brian Jacob, Max Kapustin, and Jens Ludwig use
the 1997 housing voucher lottery in Chicago (the first opening of
voucher lists in the city in 12 years). They examine the outcomes
14 years later for children whose families won housing vouchers
versus children of families that did not. Families that won the
lottery received a very large positive income shock—the equivalent
of $12,000 a year—relative to the average income in the sample
($19,000 a year).
The authors find very few effects on schooling, crime, or health
outcomes and none are significant. “Our estimates imply that
extra cash transfers beyond the current level provided in the
United States are likely to have a smaller impact per dollar than
the best-practice educational interventions explicitly designed
to improve children’s human capital,” they write. Their results
are consistent with the findings of sociologist Susan Mayer, who
concluded in What Money Can’t Buy (Harvard University Press,
1997) that there is “little reason to expect that policies to increase
the income of poor families alone will substantially improve their
children’s life chances.”
Air Pollution Regulation
“Toward a More Rational Environmental Policy,” by Richard L.
Revesz. December 2014. SSRN #2534018.
R
ichard Revesz, professor of law at New York University,
describes five principles that should govern environmental policy:
Environmental restrictions on emissions should be governed
by cost-benefit analysis and maximize net benefits.
■■ Environmental objectives should be achieved at minimum
cost.
■■ Environmental policies should be implemented with market
instruments such as emission prices or tradable emission
permits.
■■ Grandfathering of emission sources introduces fatal arbitrage problems into environmental regulation and should be
severely constrained. (See “New Source Review: What’s Old
Is New,” Spring 2006.)
■■ The most compelling case for federal regulation is the control of interstate externalities.
■■
From a libertarian perspective, the fifth principle is the most
important. And yet one ironic response of states to the passage of
the Clean Air Act amendments in 1970 and 1977 and their requirement that states enact plans to reduce stationary source emissions
was to mandate taller smokestacks—a cheap solution that solved
62 / Regulation / Spring 2015
in review
the intrastate problem by creating an interstate problem.
Rather than just reverse course and require the shortening
of smokestacks to revert an interstate problem back into a local
matter that the states would have to address, the federal courts,
Congress, and the U.S. Environmental Protection Agency have
been wrestling with the upwind–downwind problem ever since.
The record of the courts and the EPA in tackling interstate pollution (at least partially created by the Clean Air Act itself) has
not been very good. In 1984 the Sixth Circuit Court of Appeals
ruled that an upwind Indiana power plant with no emission
controls emitting six pounds of sulfur dioxide per million British
Thermal Units (BTUs) of coal combustion had not violated the
law even though it contributed almost half of the ambient pollution in downwind Jefferson County, Ky., and the power plant in
Jefferson County emitted only 1.2 pounds of sulfur dioxide per
million BTUs of coal combustion after investing $138 million in
pollution control.
The EPA did not attempt to deal with interstate air pollution
until 1998, during Bill Clinton’s second term. That effort was
halted by the George W. Bush administration, which instead
asked Congress to amend the Clean Air Act and explicitly expand
the cap-and-trade market for sulfur dioxide (created by the 1990
Clean Air Act Amendments) to include other pollutants such as
nitrogen oxides. The congressional reform attempt ended in 2005
when the bill failed to be approved by the Senate Environment
and Public Works Committee on a 9–9 tie vote.
Revesz tells the story of how the courts finally allowed the
EPA to implement a pollution reduction plan that minimized
costs (specifically an emission rights trading regime) even though
Congress failed to explicitly grant such permission through an
amendment of the Clean Air Act. (See “An EPA War on Coal?”
Spring 2013.) Shortly after the failure of the Senate committee
to approve the Bush initiative in 2005, the EPA issued the Clean
Air Interstate Rule (CAIR) to implement the Bush proposals
administratively. In 2008 the D.C. Circuit Court of Appeals
struck down CAIR because a strict reading of the statute was
thought not to allow a trading program that reduced emissions
based on the cost of reduction rather than the amount of pollution generated.
In 2011 the EPA responded with the Cross State Air Pollution rule, which again allowed the trading of emission reduction
quotas, but with constraints so that all upwind states would have
to reduce emissions rather than simply buy emission rights sufficient to allow their emissions. In 2012 the D.C. Circuit Court
of Appeals struck down the Cross State rule because state emission limits were established on the basis of the cost of reduction
rather than how much each state’s emissions contributed to the
downwind ambient result. In 2014 the Supreme Court reversed
the D.C. Circuit and concluded reductions could be allocated in
a way that minimized aggregate costs.
For Revesz the story is positive because the courts finally
allowed policy to be more rational. But that conclusion is possible
only if one thinks that the courts rescuing the legislature from its
enactment of “bad” statutes is a good thing and that interstate
conventional pollution, itself, was not the unintended result of
national attempts to make localities have “better” environments.
Bank Credit Supply and
the Great Recession
“Do Credit Market Shocks Affect the Real Economy? Quasi-Experimental Evidence from the Great Recession and ‘Normal’ Economic
Times,” by Michael Greenstone, Alexandre Mas, and Hoai-Luu
Nguyen. November 2014. NBER #20704.
B
en Bernanke’s work on the causes of the Great Depression
concluded that bank failures were an important contributor to the Depression’s length and depth. According to his
research, lending was highly localized and the supply of credit to
businesses was reduced by local bank failure.
Small firms, which are more reliant on bank lending, suffered disproportionate employment losses during the 2007–2009
“Great Recession.” Mindful of his findings on the Depression,
Bernanke and Alan Krueger have both suggested that impaired
bank credit markets were a major cause of overall employment
losses in the recent recession. Hence, the Bernanke-led Federal
Reserve implemented various direct lending programs to financial
institutions to “fix” impaired credit markets for firms.
Despite the emergence of a national banking market in recent
decades, small businesses still rely heavily on local lenders. The
median distance between firms and lenders is only about three
miles and only 14.5 percent of firms borrow from a lender located
more than 30 miles from the firms’ headquarters.
During the last recession, banks reduced their lending to
small businesses in widely varying degrees. For example, Citibank
reduced small business lending by 84 percent while US Bankcorp
reduced its lending by only 3 percent. Michael Greenstone, Alexandre Mas, and Hoai-Luu Nguyen exploit small firms’ reliance on
local lenders and the differential lending cutbacks among regional
banks to create a quasi-experimental research design.
They ask whether counties with more Citibank branches before
the crisis experienced a greater reduction in lending and greater
economic decline during the recession than counties with more
US Bankcorp branches. The answer is yes but the magnitude is
small. If you unrealistically consider all the lending decline to be
supply-driven rather than attributing some of it to a recessioncaused reduction in demand, then reduced lending would account
for just 0.5 percentage points of the 10 percent decline in small
business employment in the recession—about 5 percent of the
decline. If you use the upper bounds rather than the average of the
95 percent confidence intervals of the estimated effects, you can
explain 13 percent of the decline—a real but small effect. And this
is for small businesses; larger businesses with access to non-local
credit supply would be even less affected, if at all.
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